Business failure occurs due to different reasons. While few firms fail within first year or two of life, few others grow, mature and fail much later. The business failure can occur in a number of ways and also from different reasons.
Why Business Firms Fail
Let us try understand the different reasons why corporate often fail;
- An imbalance of skills within the top echelon.
- A chief executive who dominates a firms operations without regard for the inputs of peers.
- An inactive board of directors. The board of Directors lack of interest in the financial position of the company may lead to insolvency.
- A deficient finance function within the firm’s management.
- The absence of responsibility for the chief executive officer.
Apart from the above mistakes the firm usually is vulnerable to several mistakes;
- Management may be negligent in developing effective accounting system.
- The company may be unresponsive to change.
- Management may be inclined to undertake an investment project that is disproportionately large relative to firm size. If the project fails the probability of insolvency is greatly increased.
- Finally the management may rely heavily on debt financing that even a minor problem can place the firm in a dangerous position.
The Physiology of Business Failure
In an economic sense business failure is associated with success in business relates to firms that earn adequate return on their investment. Similarly business failure is associated with forms that cannot earn adequate returns on their investments. What is important is whether a business failure is permanent or temporary. In fact the appropriate course of action depends on whether the business failure is permanent or temporary. Thus if the failure is temporary the firm may have to be liquidated and if the failure is permanent the firm may have to take steps to the speed the company’s return to business.
Types of Business Failure
- Insolvency: A firm may fail if its returns are negative or even low. A firm that consistently reports losses at operational level would experience decline in market share and eventual closure.
- Technical insolvency: A firm is said to be facing technical insolvency when it is unable to pay its liabilities as they become due. Thus when a firm faces technical insolvency its assets are still greater than the liabilities but the firm is confronted with liquidity crisis.
- Bankruptcy: When a firm has technical insolvency some of its assets could be converted to cash to escape complete failure. If this is not done at right time, the firm may have to face a more serious type of failure — Bankruptcy. It occurs when firm’s assets are less than the liabilities. A bankrupt firm has a negative shareholder’s equity. Although bankruptcy is a more obvious form of business failure courts treat technical insolvency and bankruptcy in the same way.
When a firm faces severe problems, either the problems must be resolved or the firm must be liquidated. At such point an important question has to be answered — “is the firm worth more dead or alive.” The decision to continue operating has to be based upon – The feasibility and fairness of reorganizing the firms as opposed to the benefits of liquidating the business. When technical insolvency occurs management must either modify the operating financial conditions or terminate the firm’s life If a decision is made to alter the company in the hopes of revitalizing its operations, Either voluntary agreements with the investors, or A formal court arranged reorganization must be used. If on the other hand the difficulties are believed to be insurmountable, then liquidation will take place either by assignments of assets to an independent party for liquidation or by formal bankruptcy proceedings.
Voluntary Remedies to Insolvency
Once a firm begins to encounter these difficulties the firm’s owners and management have to consider the alternatives available to failing business. Such a firm has two remedies,
- Attempt to resolve its difficulties with its creditors on voluntary or informal process.
- Petition the courts for assistance and formally declare bankruptcy.
The company creditors also may petition to courts and get the company involuntarily declared bankrupt.
To Reorganize or Liquidate
Regardless of whether a business chooses informal or formal methods to deal with its difficulties eventually the decision has to be made whether to reorganize or liquidate the business. Before this decision can be made both the business liquidation value and its going concern value has to determine.
- Liquidation value: equals the proceeds that would be received from the sale of the business less its liabilities.
- Going concern value: equals the capitalized value of the company’s operating earnings less its liabilities.
If the going-concern value exceeds the liquidation value the company needs to be reorganized otherwise it should be liquidated.
However in practice the determination of the going concern and liquidation values is not easy due to following reasons,
- Uncertainty as to estimating the price the company’s assets will bring at auction.
- The company’s future operating earnings
- Appropriate discount rate at which to capitalize the earning may be difficult to determine.
- Management understandably is not in a position to be completely objective, about the above values.
Informal Alternatives for Failing Business
Regardless of exact reasons why a business begins to experience difficulties the result is often same cash flow problems.
The first step taken by troubled company involves stretching its payable. In some occasions this can keep the company busy for several weeks of needed time before creditors take action. If the difficulties are more than just minor and temporary the company may turn to its bankers with request for additional working capital loans.
Another possible action is the company bankers and creditors take up to restructure the company’s debt. Restructuring of debt by bankers can be quite complex. However debt restructuring basically involves either
- Composition, or
- A combination of both above.
In Extension, the failing company tries to reach an agreement with its creditors that will permit it to lengthen the time for meeting its obligations.
In composition, the firm’s creditors accept some percentage amount lees than their original claim and the company is permitted to discharge its debt obligations by paying less than the full amounts and are protected from any further actions on part of creditors while it attempts to work out a plan of re-organization.
What to Do with the Failing Firm
Another important aspect of the bankruptcy procedures involves what to do with the failing firm. Just as in case of informal alternatives a decision has to be made about whether a firm’s value as a going concern is greater than its liquidation value. Generally if this is so a suitable plan of reorganization can be formulated and the firm is reorganized otherwise it is liquidated.
If a voluntary remedy such as an extension or composition is not workable a company can declare or be forced by its creditors into bankruptcy. As a part of this process a firm is either reorganized or dissolved. Reorganization is similar to an extension or composition, the objective being to revitalize the firm by changing its capital structure — like, reduction of fixed charges by substituting equity and limited income securities in place of fixed income securities, etc.
Corporate restructuring can occur in myriad ways. Mergers, takeovers, divestitures, spin-offs, and so on referred to collectively as corporate restructuring have become a major force in the financial and economic environment all over the world.