Businesses in Distress:
Is Your Company a Candidate for Failure?
Strategic Management Partners
A nationally recognized turnaround management firm
specializing in interim executive leadership, asset recovery,
investing in underperforming distressed troubled companies.
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John M. Collard
This article is the first of a two-part series that seeks to help corporate financial managers to identify problems that may grow to threaten the very surgical of the business. This part describes the early warning signs and their possible implications. Part 2, in the Winter issue, will describe the business turnaround process arid how to deal with the critical issues of that process.
Understanding why businesses fail can help the corporate financial manager
recognize the ominous signs that portend trouble. Roughly 80 percent
or more of business failures are traceable to internal or management controlled
factors. These factors are many, including:
Instead, management must be realistic, be held accountable, and correct the situation. This is not to say that management is inept; but to survive, management must maintain a constant vigil over its operations and its objectives. Capitalism breeds both success and failure. Darwin is alive and well in the marketplace: only the fittest survive.
All businesses are as vulnerable to trouble as they are to the lure of success. We live in a world of wildly changing technologies. Even with these changes, a properly managed business will continue to prosper. However, some industries are more susceptible to trouble than others.
The fortunes of companies in cyclical industries often depend upon uncontrollable external forces such as commodity prices or weather conditions. Those most likely to withstand the effects of these forces are those that either diversify without losing sight of their objectives, or that are able to control fixed costs in the face of unstable conditions. The ability to adapt is critical.
Companies in newly deregulated industries must learn to survive in a competitive environment without the legal protections they previously enjoyed. Deregulation generally is accompanied by an anticipated shake out of the weakest businesses as competitive forces take hold in the marketplace.
As the U.S. has evolved from a primarily manufacturing driven economy to increasingly service oriented industries, management must recognize that its most irreplaceable assets walk out the door every night. Managing human resources is more important than ever.
Companies lacking a proprietary product, or "me too" companies, are subject to attack from every direction. These companies, such as retail businesses and non-licensed service sector businesses, generally face low entry barriers with respect to both capital and expertise.
Many entrepreneurial companies and start ups are limited to a single product or a passing fad. To ultimately succeed, single product and single customer companies usually must develop new products or diversify to protect themselves from powerful competitors, customers. and changing currents. Few are able to maintain their start up success as they struggle to compete. Reaching maturity takes years during which the company is vulnerable.
Rapidly growing companies often are driven bv entrepreneurial zeal and by an overwhelming emphasis on sales growth, while inadequate attention is given to the effects of growth on the balance sheet. These companies suddenly find themselves in a situation where the balance sheet simply cannot support the growth.
Highly leveraged businesses have so many factors that must converge to be successful that they are often most susceptible to the external uncontrollable causes of business failure. such as interest rate fluctuations or an increase in raw material costs.
Closely-held and family-owned businesses, bv their nature, select leadership based not on managerial ability but by virtue of family or close personal relationships with the shareholders. More than in other businesses, owner/managers link their personal psyche to that of their business. Owner/managers often believe that they are irreplaceable or are afraid to admit it. They want to maintain control ad infinitum, "'ailing to either develop a management team or a plan for transition of management. Owner/managers are reluctant to acknowledge the early warning signs of failure and are also apt to ignore them.
Perhaps declining industries face the most challenging task of all in preventing failure. Declining industries are those in which total industry wide unit shipments are declining. Maintaining market share involves taking business from competitors. Management that refuses to admit that the industry is declining or bets its future on the industry recovering, is the most prone to failure.
Entrepreneuria1 hazards. Approximately 70 percent of entrepreneurs and start-ups fail within two years. Entrepreneurs do not necessarily have managerial abilities. They have visions of what the future will look like before the rest of us know to invent the better mouse trap. Their modus operandi is to capitalize on their head start as a way to convert their vision to a profitable reality. The same skills that keep an entrepreneur focused on an idea, regardless of obstacles, can make him oblivious to the competition on his heels or to new changes in the market. Ultimately the market catches up, forcing the entrepreneur to compete in a mature industry rather than in an emerging industry. As entrepreneurs survive the transition to professional management and new technologies gain a stronghold on the economy. emerging industries are born.
What are the warning indicators of a business heading toward trouble?
Trouble can come from a variety of circumstances. The obvious signals arc
rarely the root cause of the problem. Losing money; for example, is not
the problem; it is the result of other problems. The list of warning indicators
below is by no means all inclusive, but it may provide both a barometer
and some insight as to why the company is facing difficulty: They include
Indicators connected with a company's operational performance include:
Symptoms associated with a business' poor utilization of assets include:
These are merely indicators and not the problems. They are simply the evidence that a problem exists; it is the problem, rather than the symptom, that must be identified and remedied.
Several formulas exist to predict failure. One widely known formula is the Z-Score, developed by Professor Edward Altman of New York University. By. weighing various financial ratios, the Z-Score attempts to predict whether a manufacturing company is a bankruptcy candidate. The formula:
Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
A second statistical method developed by Jarrod Wilcox, a former assistant professor at MIT's Sloan School of Business, is known as the Gambler's Ruin Prediction of Bankruptcy. This formula, designed to predict possible bankruptcy for both manufacturing and retail companies up to five years in advance, is as follows:
Liquidation Value = Assets - Liabilities
If these computations indicate negative amounts, the company is considered a candidate for bankruptcy.
Management must attempt to understand its business needs, and it should
be willing to face some highly difficult issues. With statistics generally
pointing to mismanagement at the root of most crises, management should
adopt a mindset that it wants to participate in the recovery, that it may
need the help of a turnaround specialist to be the catalyst to the recovery,
and that it wants to learn as much as possible so that it can better manage
the business on the other side of the turnaround engagement. Therefore,
management should ask itself some hard questions:
The process of recovery, when using a turnaround specialist, involves several stages.
Implementation of the business plan. Once the course of action has been chosen, the turnaround specialist should be involved in implementing the plan, either as an interim manager or as a consultant to management. This is the time a specialist begins to build the team of players both inside the company and from outside resources.
Monitor the business plan. The turnaround specialist should keep vigil over the plan, analyzing variances to determine their causes, and the validity of the underlying assumptions.
Stabilization and transition. Assuming that liquidation is not the cornerstone of the business plan, the turnaround specialist should remain involved in the engagement until the business has achieved stabilization and to assist the business in a transition of management if necessary.
John M. Collard is chairman and a director of the Turnaround Management Association. He is president of Strategic Management Partners, Inc., an Annapolis, Maryland based transition and turnaround management firm that specializes in valuation enhancement, corporate renewal, strategic repositioning, defense conversion and transition to new market segments. He can be reached at (410) 263 9100. This article is adapted with permission from the Turnaround Management Association's 1993 Directory of Members and Services, written by John M. Collard.
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John M. Collard, Chairman
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