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EARLY WARNING
INDICATORS OF BUSINESS
FAILURE
T
What is a Failure?
One of the most difficult tasks of researchers in analyzing failures is to define the term "failure." The word
FIGURE 1
Failure Process
Ineffective or
Bad Management
Leads to
Mistakes in
Strategic Plan
and/or its Implementation
Cause
Deterioration
m Performance
Indicators
In absence of no
corrective action,
or an ineffective
corrective action
a/
Leads to
Failure
Unanticipated
or
Unforseeable
Events
TABLE 1
Sample Description
Failed Firms
Firm
Giant
Beck
Simon
Ay res
Federals
National Bellas
Interstate
Ancorp
Fishman
Grant
Hartfield-Zody's
Arlans
Miller-Wohl
Kenton
Big-Bear
Bohack
Harvest
Penn-Fruit
Mangel
Unishops
Coit
Botany
Horn and Hardart
Year
Chapter 11
Filed
1973
1970
1970
1972
1973
1973
1974
1973
1974
1975
1974
1973
1973
1974
1976
1975
1974
1975
1975
1973
1975
1971
1971
(1950)
(1932)
(1935)
(1896)
(1932)
(1932)
(1928)
(1934)
(1927)
(1937)
(1945)
(1957)
(1932)
(1968)
(1933)
(1913)
(1961)
(1952)
(1929)
(1947)
(1967)
(1966)
(1898)
Primary
Business
Discount stores
Shoes and Apparel
Variety and hardv^rare
Department stores
Department stores
Department stores
Department stores
Fast food restaurant
Department store
Variety stores
Women's apparel
Department store
Women's apparel
Variety and jewelry
Supermarket-grocery
Grocery stores
Supermarket-grocery
Supermarket-grocery
Women's apparel
Men's and boys' apparel
Fabrics and sewing notions
Men's and boys' wear
Fast food restaurants
No. of
Stores
15
257
a
1
52
84
120
400
52
1086
62
111
212
23
43
4
14
70
150
326
69
101
a
Failure Process
A systematic study of failures requires a model of the
underlying failure process. To understand the failure
process one needs to know the planning process of a
given firm. The success of any business firm is a result
of the interaction of two major sets of factors. First, the
performance of an enterprise is influenced by a variety
of factors emanating from outside the business itself and
thus beyond the control of business managers (uncontrollable variables). Such environmental conditions as
the rate of growth of the economy, shifting preferences,
attitudes, and behavior of consumers, and changing
structure and operating characteristics of the marketplace clearly influence the profitability and market strength
of individual businesses.
The other major factors influencing the performance
of a business enterprise emanate from inside the firm.
They determine the firm's ability to use its resources to
adapt to and take advantage of the constantly changing
environment. Through a continuous process of formulating strategic market plans and executing, monitoring.
82 / Journal of Marketing, Fall 1980
'We recognize that all firms do not have a strategic market plan. In
fact, some firms may not have a formal "plan." The absence of a
strategic market plan or a "plan" may itself be a cause of poor performance (see, for example, Karger and Malik 1975).
TABLE 1 (continued)
Nonfailed Firms
Firm
Jamesway
Genesco
A-Dry Goods
Caldor
Kings
Outlet
Zayre
Ginos
Hecks
Woolworth
Cornwall
Fed-Mart
Winkleman
Richton
Kroger
Lucky
Penn-Traffic
Supermarket
Lane-Bryant
Mays
House-of-Fabrics
New Process
Host
(1966)
(1968)
(1916)
{19611
(1961)
(1925)
(1962)
(1960)
(1959)
(1911)
(1935)
(1954)
(1928)
(1969)
(1902)
(1931)
(1903)
(1966)
(1920)
(1927)
(1946)
(1924)
(1914)
Primary
Business
Discount stores
Footwear, men's wear
Department stores
Variety stores
Variety stores
Department stores
Discount stores
Fast food restaurant
Discount stores
Variety stores
Variety stores
Low-margin retail stores
Women's apparel
Variety and jewelry
Supermarket-grocery
Supermarket-grocery
Department stores
Supermarket-grocery
Women's apparel
Department stores
Fabrics and sewing notions
Mail order
Fast food restaurants
No. of
Stores
50
1500
3
50
187
21
251
506
160
3796
193
58
87
a
1202
1317
44
109
188
8
560
188
TABLE 2
Description of Financial Performance
Indicators
Profitability
1. Return on Assets:
Earnings Before Interest and Taxesn'otal Assets
Leverage Ratios
2. Debt Service:
Earnings Before Interest and Taxes/Interest
Coverage
3. Cash Flow:
Cash Flow/Total Debt
4. Capitalization:
Market Value of Equity/Total Capital
Liquidity Ratios
5. Current Ratio:
Current Assets/Current Liabilities
6. Cash Turnover:
Net Sales/Cash
7. Receivables Turnover:
Net Sales/Receivables
8. Inventory Turnover:
Net Sales/Inventories
9. Sales Per Dollar Working Capital:
Net Sales/(Current Assets - Current Liabilities)
Miscellaneous
10. Retained Earnings/Total Assets
11. Total Assets (in thousands of dollars)
^In recent years some attempts have been made to study empirically the
relationships among various strategic variables and to identify the determinants of market and financial performance. The scope of these sUidies
has ranged from the identification of determinants of profitability for a
specific industry (e.g.. Schendel and Patton 1978) to the formulation of
"propositions" of corporate strategy (e.g.. PIMS). The most substantial
attempt yet in the field of business policy and corporate strategy is an
ongoing study being conducted by the Strategic Planning Institute (refened to as the PIMS program). See Wind and Mahajan (forthcoming)
for details of this program.
FIGURE 2
Mean Current Ratio and Return on Assets
for Failed and Nonfailed Firms
Figure 2
Mean current ratio and retum on assets tor tailed and non-tailed finns
3-
.Q
2-
Current
Non-failed
04
Year to failure
- 1
^o
Return on assets
0.2-
^\
Year to failure
-0.1 -
The Model
-0-2-
FIGURE 3
Scores of Failed and Nonfailed Firms
One Year Prior to Failure
Failed nmis
Arlans
Mange)
Hardart
Kent
"^
.^ ~--,
.- ^ ~~- .-^"~--
Grant
Federals-_^^
Ancorp
~~^__
Bohack
^_
NahonaJ-Bellas
Mjller-Wohl
Hartfield-Zody
Unishops
Botany
Beck
Penn Fruit
Fishman
Coit
Big Bear
2.0
-3.5
-3.0
-2.5
-2-0
25
3.0
-1.5
New Process *^'
Genesco
Kings
House c1 Fabrics
Hecks
Lane Bryant
Outlet
Host
TABLE 3
Means and Standard Deviations of Indicators
Year to Failure
1
indicator^
Failed
Nonfailed
Year to Failure
2
Nonfailed
Failed
-.130
(.226)
.139
(.050)
-.020
(.240)
.135
(.047)
2. Debt service
-5.092
(12.587)
17.885
(38.352)
-.567
(10.243)
39.686
(79.33)
3. Cash flow
-1.551
(5.292)
1.342
(3.419)
.162
(.603)
1.207
(2.806)
4. Capitalization
.382
(2.014)
1.364
(1.113)
1.125
(1.087)
1.909
(2.806)
5. Current ratio
1.628
(.994)
2.295
(.967)
1.658
(.571)
2.549
(1.184)
6. Cash turnover
43.667
(28.240)
69.680
(106.660)
52.562
(50.735)
49.732
(50.385)
7. Receivables turnover
44.436
(63.201)
81.329
(92.081)
35.527
(56.001)
65.914
(72.181)
8. Inventory turnover
18.630
(35.883)
11.734
(16.304)
9.198
(12.388)
10.138
(11.580)
17.894
(48.442)
11.554
(8.815)
9.997
(38.708)
10.050
(8.506)
-.179
(.532)
.302
(.129)
.159
(.193)
.304
(.132)
127.878
(265.720)
302.568
(534.346)
126.977
(262.901)
253.738
(452.683)
1. Return on assets
2. The development of a comprehensive set of indicators reflecting the fmancial performance in terms
of profitability, leverage, and liquidity. These
indicators have been shown to measure the financial health of firms (Van Home 1977).
3. Data availability that permitted the calculation of
certain indicators across firms and across years.
Data on 11 performance indicators were taken from
Moody's Industrial Manual for five years prior to failure for failed firms and for a corresponding five-year
period for each nonfailed firm. Table 3 gives the mean
and standard deviation for each indicator across the five
years for failed and nonfailed firms, respectively. Mean
values of two indicatorsreturn on assets and current
ratioare depicted in Figure 2. Visual examination of
mean values suggests the differences between failed and
nonfailed firms on these indicators.
A two-group discriminant analysis was conducted to
find the "best'' linear discriminant functions for the
five years prior to failure. Table 4 is a summary of the
results. Wilk's lambda values, canonical correlations,
TABLE 3 (continued)
Year to Failure
4
Year to Failure
3
Failed
Nonfailed
Failed
Nonfailed
Year to Failure
5
Nonfailed
Failed
.0922
(.050)
.058
(.055)
.146
(.058)
.073
(.054)
.153
(.060)
5.400
(5.955)
16.529
(17.774)
6.445
(9.202)
15.083
(12.887)
7.559
(9.441)
13.455
(10.829)
.426
(.868)
1.159
(2.355)
.352
(.587)
.710
(.677)
.536
(.679)
.742
(.639)
.946
(.690)
2.575
(2.195)
1.203
(1.0061
3.531
(3.241)
1.338
(.897)
3.856
(4.119)
1.751
(.537)
2.508
(1.213)
1.915
(.781)
2.273
(.838)
1.923
(.613)
2.401
(1.236)
78.848
(98.628)
42.105
(32.667)
44.44
(58.190)
35.884
(19.962)
47.939
(32.942)
53.563
(73.590)
46.462
(49.368)
89.948
(136.478)
44.710
(51.559)
68.757
(77.579)
84.072
(101.195)
57.610
(92.199)
10.606
(12.201)
10.496
(10.562)
8.961
(8.949)
10.555
(12.121)
11.359
(10.794)
9.522
(5.494)
16.220
(21.779)
10.923
(9.939)
13.000
(16.074)
10.653
(7.878)
16.972
(14.419)
12.193
(12.665)
.203
(.149)
.311
(.126)
.232
(.142)
.319
(.129)
.289
(.122)
.337
(.127)
123.734
(246.50)
223.794
(400.900)
114.848
(216.691)
206.051
(371.346)
137.281
(246.707)
266.937
(426.135)
.155
(.051)
TABLE 4
Discriminant Analysis Results
Year Before Failure
1
Weights
Return on Assets
Current Ratio
Constant
3.679
0.380
-0.862
3.031
0.630
-1.534
7.905
0.443
-1.875
10.831
0.201
-1.779
10.298
0.417
-2.277
Canonical Correlation
Wilk's Lambda
Chi square
Significance
Number of Companies Available
Classification Rate (%)
Classification Rate (%)
(Lachenbruch Holdout Method)
0.651
0.576
18.230
.000
36
91.67
0.531
0.718
14.259
.001
46
78.26
0.539
0.710
14.745
.001
46
73.91
0.491
0.759
11.286
.004
44
75.00
0.564
0.682
8.790
.012
26
80.77
91.67
78.26
73.91
12.12
76.92
Conclusion
We stress the importance of analyzing failures and propose a failure process model. The model suggests that
failures can be predicted by analysis of either the causes
88 / Journal of Marketing, Fall 1980
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