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Unit2

Reasons for Corporate Failure

Arjun Madan Ph D

Corporate Failure

Corporate failure could be seen in terms of the inability of a

corporate organization to confirm itself with its strategic path
of growth and development to attain its economic and
financial objectives as well as legal obligations.

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Why Companies Fail?

 Many corporate bodies fail as soon as they are established
because of -
 Inappropriately formulated strategy or lack of it.
 this could be traced to managerial inefficiency and ineffectiveness
 Its inability to appropriately apply financial resources available
to it.
 this can create a liquidity problem adversely affecting different
aspects of corporate operations.

 Failed corporate entities can still be in existence for quite some

time without the knowledge of shareholders.
 This could be traced to different forms of window dressing
effected by management with the collusion of external auditors.

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Why Companies Fail?

 The assumption that failure or sudden collapse is news to the
public, but not to management, is not borne out by the facts.
 The violations of basic business principles and the consistent
pattern of mistakes give credence to hindsight in the case of
business failure and decline.
 Spectacular business failures that suddenly hit the headlines
were years in the brewing.
 The warning signs and symptoms of decline should have been
apparent to a concerned, sensitive management.

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External Causes
of
Failure

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The Impact of Change

 In today's unstable planning climate,
 unions can shut down industries overnight;
 government regulations can force capital expenditures for pollution
control, noise abatement, safety and health improvements;
 consumer organizations can suddenly place artificial pressures on
pricing or quality;
 energy and raw material shortages can interfere with production
or create great variance in costs;
 government can increase business incentives (investment credit,
solar power, tax credits, etc.) and just as quickly take them away.

 Are the few trends and events that strike at the core of a
company's business

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The Impact of Change

 External factors can be divided into two types:
 external changes and
 external constraints.
 The difference between the two lies in their degree of severity.
 External constraints block management action and, as such,
are more difficult to deal with than most external changes,
 Eg. government constraints

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The Impact of Change

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Economic Failure
 From an economic standpoint, failure represents a situation
where the realized rate of return on invested capital is
significantly lower than prevailing rates on similar investments.

A company can be an economic failure for

years and yet, in the absence of legally
enforceable debt, be able to meet its current
obligations and thus not be a legal failure.

 Environmental economic instability can lead to corporate failure.

 The reason being that any downturn in the economy can create
some form of financial distress due to a firm’s inability to sell its
products (Caballero and Hammour, 1994)

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Economic Failure
 A boom covers many sins, and a bust uncovers many weaknesses.
 Economic problems come in many forms, including
 slackening overall demand,
 devaluation of currencies,
 sanctions and tariffs war
 political uncertainty
 international monetary crises,
 high fiscal deficit,
 interest rate hikes, and
 credit squeezes (it is one of the most potent causes of collapse)

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Economic Failure
 Edward Altman developed the following equation to links
failure rates with GNP, the stock market index, and the money
supply:
FR = 1.54 - 0.222GNP, - 1.90SP, + 0.495MS + e
 where FR is the change in the failure rate from one quarter of the
year to the next;
 GNP, is the change in GNP in billions of dollars between those
quarters;
 SP, is the change in the Standard and Poor Index of Common
Stock Prices;
 MS, is the change in the money supply in billions of dollars; and
The
e isequation
an error term.
is good for measuring failure rate in small and
medium size companies
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Economic Failure
 Economic change are responsible only for a fraction of corporate
failure
 Well-managed company outperforms even the better giant
corporations in bad times as well as good.
 They do so through
 disciplined control over the economics of the business,
 intensive development of the right market niches and products,
and,
 a leadership style that sustains entrepreneurial drive and
commitment among its key managers.

 Good management can offset poor economic conditions.

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Competitive Change
 A world of constantly shifting competition cause changes -
 The emergence of foreign, low-cost producers,
 the merger of two competitors,
 the announcement of a competitor's new range of products,
 the appearance of an entirely new company in your industry

 that can have a profound impact upon your company.

 If you don't keep your ear close to the ground,
 try to calculate and quantify the consequences of such changes,
and
 take appropriate action,
 Then your are certain to lose some of your competitive edge.

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Competitive Change
 Competition can cause decline, but usually this happens to
companies that are not monitoring the outside environment.
 Eg. NCR, Nokia, Kodak, Consumer Electronics
manufacturers(India) Soft-drinks, etc

 Turnaround executives believe that competitive change

accounts for about one-quarter of externally caused decline

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Government Constraints
 Politicians are playing a growing role in business all over the
world.
 New quotas and duties and taxes and levies and legislation of
all sorts pour out of government agencies.
 Even more insidious are the changes in political attitudes
toward business in general and certain industries in particular.
 The government impinges on corporate life by :
 taxation,
 involvement in employee records,
 welfare legislation,
 pollution control, and product safety and
 consumer welfare legislation

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Social Change
 A fairly long time span is required to accommodate many of the
changes in society.
 When companies do not see, or do not react to social trends
such as -
 changes in life-styles,
 in composition by age or gender of a given population, and
 in attitudes toward pollution and consumer decline.
 They risk loosing their market share.
 Since social change affects some industries much more than
others, for ex. entertainment business or a style-oriented
business, they have to be more adept at monitoring social
change.
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Social Impact
 Unsuccessful business is viewed as a negative economic event,
both to the principals of the economic entity and to society in
general.
 Besides the obvious and quantifiable costs to employees,
creditors, and owners, there are serious second-order effect
borne by the community at large.
 suppliers suffer reduced demand,
 customers are often inconvenienced, even if alternative goods or
services are available,
 the public is forced to shoulder a portion of overall bankruptcy
costs because of increased tax burdens.

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Social Impact
 However, not everyone agrees that the long-range social impact
of corporate failure is negative.
 Many economists advocate the cleansing effect business failure
has on competition and innovation.
 The competitive environment is often favorably cited for its
weeding out of inefficient and poorly managed entities in order
to perpetuate a healthy, vibrant economy.

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Technological Change
 Technological progress has created new materials, processes, and
manufacturing techniques.
 The possible combinations of products and the means of getting
them staggers the imagination.
 Consumers can choose from a host of options in materials, quality,
price, service features, dependability, style, color, and shape.
 But the need to create and satisfy product demands has put
manufacturing organizations in the contradictory position of being
both contributors to change, and its victims.
 Companies that are victims of technological change are
only victims of their own lack of foresight.

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Internal Causes
of
Failure

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Internal Reasons for Decline

 In seven out of ten cases decline is internally generated.
 “Obviously, the primary cause for decline is bad management.
The main reason why corporations get into trouble is failure to
recognize the signs when things are starting to rot at the core.”
~ Robert Brown

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Internal Reasons for Decline

 The problem of bad management can be better understood by
answering three key questions:
 1. Why does "bad" management exist?
 2. What are the visible symptoms of bad management?
 3. What are the most common errors that bad management
commits or omits that cause corporate decline and failure?

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Why Bad Management Exists

 Incompetence
 Bad management exists for many of the same reasons other
human problems exist - it's that old common denominator –
people.
 Most business problem are generally people problem, not a
product problem.
 If your product costs too much, it's generally because of people.
 If your product is not the quality of your competitors', that's
usually because of people.
 Seventy-five percent of most problems are people.

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Why Bad Management Exists

“It all boils down to human frailties. Some people have the natural
abilities to manage and some don't. In lots of situations somebody
incompetent will be promoted into top management. If the business
factors are all lining up reasonably well, it probably doesn't matter.
In rough economic times or in an unusually competitive situation,
management is not capable of dealing with the adverse factors.” ~
Glenn Penisten of American Microsystems

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Why Bad Management Exists

 Narrow Vision
 Often companies promote a man into the top position because
he has had some success in a narrow functional area.
 This narrow outlook can be dangerous because the president's
job requires breadth of vision.
 The widening of one's horizons can be a frustrating, harrowing,
and even dangerous experience for the unprepared individual
and the company alike.
 Eg. A company elevated a vice president to company president as
a reward for outstanding success in sales.

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Why Bad Management Exists

 Displacement Activity
 Many a businessman is so busy doing the things he likes to do
that he has no time for the things he should do.
 This form of displacement activity can reach dangerous
proportions in a troubled company.
 Eg. A company chief executive spending time on engineering
drawing board believing that no one can design a new rolling mill
except him, while his company's financial position severely
deteriorated.

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Why Bad Management Exists

 Displacement Activity
 It amounts to an appalling lack of objectives and discipline.
 The board of directors does not discipline top management; top
management does not discipline middle management; and so on
down the line.
 The lack of discipline is an important reason for business
failure.
 In the final analysis discipline means
 people looking at things when they should look at them,
 recognizing what they should see when they do see it, and
 doing something about it once the impact of what it all means is
seen.
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The Visible Symptoms of Bad Management

 Experience and research confirm that the principal symptoms
of bad management are:
 (1) one-man rule,
 (2) lack of management depth,
 (3) management succession problems,
 (4) inbred bureaucratic management,
 (5) a weak financial executive,
 (6) an unbalanced top management team, and, finally,
 (7) a non-participative board.

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Management Errors
 If management of a company is poorly handled, it will make
two types of errors:
 errors of omission and
 errors of commission.
 Errors of omission fall into two main categories:
 (1) the company fails to respond properly to changes in its
external environment, and
 (2) it is lax in developing or utilizing control information.

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Management Errors
 The errors of omission – when the company fails to develop and
communicate a unified and directed strategy to which all
members of the organization can relate.
 The lack of strategy will eventually lead to errors of
commission that put the company in grave danger.
 For example -
 The company may over-expand while becoming noncompetitive.
 As the company declines, it will compound its errors by borrowing
and becoming excessively leveraged.

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Inbred Bureaucratic Management

 Organizations can decay because their people structure becomes
too rigid.
 As organizations mature and management becomes entrenched,
they tend to become rigid and unresponsive to change
 It loses its capacity to meet challenges from unexpected directions.
 Trying out new ideas means taking chances, and each has a degree
of risk associated with it.
 Senile organizations are so controlled that they don't take chances.
 Because some internal forces demand change while others resist it,
all organizations are in tension and conflict.

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Six Danger Signs of Inbred Management

 1. People cling to old ways of working even though they have been
confronted by a new situation.
 2. They fail to define new goals with meaning and challenge.
 3. Action is taken without studied reflection.
 4. Institutionalized contentment: Business becomes secure and
stable, not venturesome.
 5. Old "wisdom" is passed on to new people. Older managers tend
to adhere too rigidly to old ideas, to antiquated approaches and
methods.
 6. Low tolerance for criticism acts to stifle independent thinking.

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The Unbalanced Top Management Team

 The phenomenon of imbalance is plainly visible in many
engineering companies, where both the chief executive and the
board members are engineers.
 This arrangement suits the autocrat, for none of his
subordinates will challenge him on engineering decisions,
 If the management does not contain a wide spectrum of skills,
then the chance of a new threat appearing unnoticed is severely
increased.

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Weak Finance Function

 A special case of imbalance in the top team – particularly at board
level – is a weak finance function resulting in inadequate financial
and accounting controls.
 Even when these systems are perfectly adequate, their message
may not be heard at board level because the finance function is
not strongly represented there.
 A strong finance man organizes his function and articulates it
from the top.
 To be "good," the chief financial officer must have technical skills,
be creative, and have the courage and ethics to stand up to the
chief executive officer

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