Financial distress and corporate failure: Causes, Prediction, mitigants

It is generally accepted that the key factors making the difference between companies that fail and the ones that survive are profitability, Return Of equity, gearing or debt levels, cash flow and volatility in business revenue.

All companies face risk in their everyday operations. The risk would be higher if a company operates in a volatile clime where there are policy inconsistencies, high inflation rate, unfavorable interest rate and other external risks factors that can negatively affect its corporate existence which could also lead to financial distress if not properly managed.

Financial distress is simply a situation where a company’s operating cash flows are not sufficient to satisfy current obligations and the company is forced to take corrective action. Financial distress can serve as a company’s warning device. For instance, a company with a very high gearing level (more debt finance) will experience financial distress earlier than one with a low gearing (less debt finance). The effect of this is that suppliers providing goods and services on credit terms are likely to reduce the generosity of their terms, or halt supplies, if they notice there is an increased chance of the company not being in existence in a few months time. It may also lead to default on a contract. Bankers and lenders will tend to overlook a financially distressed company who’s in need of further finance. This may continue for many years even after the crisis has passed.

Corporate failure occurs when a company becomes insolvent and goes out of business. Companies that fail have obviously performed badly. Insolvency is the inability to pay one’s debt as at when due. In such situation, the assets will be insufficient to discharge the liabilities. After a company has failed, it should be possible to analyse the reasons why failure happened and what went wrong. If management can identify the signs of failure in advance, they might be able to take steps to deal with the problems and prevent it from happening.

Corporate failure can be predicted. There are two differing views about its prediction. One view is that it is caused by financial problems such as losses or liquidity problems while another view is that the causes of failure are not financial. Financial problems are the consequences of other problems, and failure is caused by these other non-financial reasons. Predicting the failure of companies may be based on either a quantitative approach or a qualitative approach. If failure can be predicted by the existence of financial problems, it should be possible to use financial ratios and quantitative analysis to predict the failure. On the other hand, if the causes of failure are non-financial, it might be necessary to use qualitative measures of performance and judgement to predict failure.

As they say, there’s no smoke without fire. This brings us to the real causes of corporate failure which might be poor management; company’s inability to retain key staffs is also a major factor that might cause corporate failure. Other factors includes poor management systems, the loss of a big client, a large increase in interest rates, ownership of the company in the hands of a small number of individuals, lack of internal controls, poor business planning, poor financial planning, poor marketing, lack of innovation, declining sales, lack of reinvestment towards the replacement of ageing non-current assets, the postponements of necessary capital expenditure, falling market share for listed companies and increasing rate of staff turnover.

When a company is seen to be at risk of failure, measures should be taken to reduce the risk. The measures that are needed may be apparent from the causes of failure. Many writers have suggested what should be done to avoid failure. For example, Ross and Kami ,in an article on “why the mighty fall” recommended Ten Commandments which should not be broken. For a company to avoid failure, it must have a strategy. It must have strong internal controls. The board of directors must participate. It must avoid a system of a “one man rule”. There must be management in depth. It must keep itself informed of change, and react to it. The customer must be treated like a king. It must not misuse computers. The business must not manipulate its accounts (avoid window dressing). The business must always organize to meet the needs of its employees to a reasonable extent.

Adeniyi Bamgboye is an advisor on accounting, audit, tax and business. He holds an MBA in financial management and a member of Association of Certified Chartered Accountant (ACCA-UK), Institute of Chartered Accountants of Nigeria (ICAN) and the Chartered Institute of Taxation of Nigeria (CITN) He can be reached on 08060603156 (Text only), bamgboyeadeniyi@yahoo.com

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