FINANCIAL STATEMENT ANALYSIS
Lesson 7
FINANCIAL DISTRESS AND CORPORATE FAILURE
Learning objectives
At the end of the lesson participants should be able to;
Identify symptoms of financial distress
Select appropriate model for prediction of corporate failure
Interpret the failure index
Lecture outline
Introduction to financial distress
Types of failures
Corporate Failure Prediction Model
7.1 Introduction
Financial distress is a term used to indicate a condition when promises to creditors of a company
are broken or honored with difficulty. Sometimes financial distress can lead to bankruptcy. When
a firm is under financial distress, the situation frequently sharply reduces its market value,
suppliers of goods and services usually insist on COD terms, and large customer may cancel their
orders in anticipation of not getting deliveries on time. Financial distress is usually associated
with some costs to the company; these are known as costs of financial distress. Examples include;
bankruptcy costs like auditors' fees, legal fees, management fees and other payments
Corporate Failure
Corporate failure refers to companies ceasing operations following its inability to make profit or
bring in enough revenue to cover its expenses. This can occur as a result of poor management
skills, inability to compete or even insufficient marketing.
When a business fails, it happens because it ran out of cash. In technical terms – it became
insolvent. Businesses basically run out of cash for a variety of reasons:
1. Lack of profit – the available cash was not enough to cover the losses caused by
inadequate business performance.
2. Excess illiquid assets – the business has tied up too much of its cash in plant and
machinery, property, slow-moving stock or the development of a new product and thus
has insufficient left to fund its trading.
3. Too much growth – the business’s transactions are expanding faster that the cash
resources needed to fund them.
64
, FINANCIAL STATEMENT ANALYSIS
7.2 Types of Business Failure
Generally, business failures can be divided into three types.
1. The business that never starts
These are businesses that fail almost as soon as they start. Some of the more common causes are:
The business model is wrong – the anticipated market does not exist.
The business is undercapitalized: it runs out of cash when trying to establish itself and to
prove its market.
The business survives the early stages of formation, but it hasn’t become sufficiently
established with enough reserves. In other words, it cannot function in times of lower
economic activity.
The business has been set up in a high-growth industry, but it doesn’t survive the burst
of “the bubble”. It is a common phenomenon in new or suddenly popular sectors.
Businesses enter the market expecting easy profits, but they find that the initial growth
slows or even reverses and leaves them facing a slowing demand.
The business owner doesn’t have the necessary skills or the drive to see the business
through.
2. The catastrophic failure
These types of business failure are surprisingly rare. They are traumatic events whose effect can
be significantly reduced by good management and include:
A major fire or flood – These kinds of catastrophes may be regarded as the “act of God”,
but the consequences can be lessened or even avoided by using insurance cover and
contingency planning.
Major fraud – Potentially catastrophic. The management should take steps to insure this
does not happen. Simple controls and procedures can minimize the risk and the potential
damage caused by such events.
Government act – Sometimes governments make legislative changes that can prevent a
business form operating overnight. More often, the governments change the rules by
which business is done. Although some notice is usually given, these changes come faster
than some businesses can adapt. In this case only the well managed and well run
businesses will be able to survive.
Major litigation – For example, litigation over an alleged patent infringement can also be
detrimental to a company. It is up to the management to have the foresight to deal with
this sort of risk.
65
Lesson 7
FINANCIAL DISTRESS AND CORPORATE FAILURE
Learning objectives
At the end of the lesson participants should be able to;
Identify symptoms of financial distress
Select appropriate model for prediction of corporate failure
Interpret the failure index
Lecture outline
Introduction to financial distress
Types of failures
Corporate Failure Prediction Model
7.1 Introduction
Financial distress is a term used to indicate a condition when promises to creditors of a company
are broken or honored with difficulty. Sometimes financial distress can lead to bankruptcy. When
a firm is under financial distress, the situation frequently sharply reduces its market value,
suppliers of goods and services usually insist on COD terms, and large customer may cancel their
orders in anticipation of not getting deliveries on time. Financial distress is usually associated
with some costs to the company; these are known as costs of financial distress. Examples include;
bankruptcy costs like auditors' fees, legal fees, management fees and other payments
Corporate Failure
Corporate failure refers to companies ceasing operations following its inability to make profit or
bring in enough revenue to cover its expenses. This can occur as a result of poor management
skills, inability to compete or even insufficient marketing.
When a business fails, it happens because it ran out of cash. In technical terms – it became
insolvent. Businesses basically run out of cash for a variety of reasons:
1. Lack of profit – the available cash was not enough to cover the losses caused by
inadequate business performance.
2. Excess illiquid assets – the business has tied up too much of its cash in plant and
machinery, property, slow-moving stock or the development of a new product and thus
has insufficient left to fund its trading.
3. Too much growth – the business’s transactions are expanding faster that the cash
resources needed to fund them.
64
, FINANCIAL STATEMENT ANALYSIS
7.2 Types of Business Failure
Generally, business failures can be divided into three types.
1. The business that never starts
These are businesses that fail almost as soon as they start. Some of the more common causes are:
The business model is wrong – the anticipated market does not exist.
The business is undercapitalized: it runs out of cash when trying to establish itself and to
prove its market.
The business survives the early stages of formation, but it hasn’t become sufficiently
established with enough reserves. In other words, it cannot function in times of lower
economic activity.
The business has been set up in a high-growth industry, but it doesn’t survive the burst
of “the bubble”. It is a common phenomenon in new or suddenly popular sectors.
Businesses enter the market expecting easy profits, but they find that the initial growth
slows or even reverses and leaves them facing a slowing demand.
The business owner doesn’t have the necessary skills or the drive to see the business
through.
2. The catastrophic failure
These types of business failure are surprisingly rare. They are traumatic events whose effect can
be significantly reduced by good management and include:
A major fire or flood – These kinds of catastrophes may be regarded as the “act of God”,
but the consequences can be lessened or even avoided by using insurance cover and
contingency planning.
Major fraud – Potentially catastrophic. The management should take steps to insure this
does not happen. Simple controls and procedures can minimize the risk and the potential
damage caused by such events.
Government act – Sometimes governments make legislative changes that can prevent a
business form operating overnight. More often, the governments change the rules by
which business is done. Although some notice is usually given, these changes come faster
than some businesses can adapt. In this case only the well managed and well run
businesses will be able to survive.
Major litigation – For example, litigation over an alleged patent infringement can also be
detrimental to a company. It is up to the management to have the foresight to deal with
this sort of risk.
65
