This blog is written by Mr. Agha Mudassar Khan, Manager Taxation, Corporate and Accounting Services. Please read this technically explained Blog and provide us your useful comments.
CORPORATE FAILURES AND HOW TO SEE THEM OFF
Corporate failure can be defined as the incapacity of an entity to keep itself abreast with its strategic path of growth and development to attain its economic, financial objectives as well as legal and social obligations. More simply, it is a situation when a corporate business no longer, is in a position to continue its future operations and is apparently steering itself towards cessation either voluntarily or compulsory.
Why to consider Corporate Failure?
Corporate failure is often considered to be a topic of great curiosity for corporate managers, who are destined at the throne of sailing a corporate business towards its envisioned success and are actively looking for possible, probable and certain pitfalls, which may hamper from outreaching them. In any case they would always be on the receiving end, if disaster ever occurs, either through loss of employment, termination benefits cuts, loss of reputation, stature, bad press and in rare but extreme cases litigation.
But, not only the business managers would be at loss of a business failures, yet it may trigger havoc on many others, such as, unemployment, depriving creditors from recovering their legitimate earnings, loss of taxes for government, loss of business for customers (especially, if their product or service is highly dependent on a failed business), increased poverty and enhanced crime rates etc., particularly if takes place at a mass place or affects a major sector of economy. Hence corporate failure also gets frequent attention of all other stakeholders, such as government, job market, lenders and financial institutions and general public as they can also become direct and indirect casualty in many ways.
Collapse of Lehman Brothers in 2008, is one prime example, the sort of misfortune, corporate failure to a single entity can bring to the world at large within such a short scale of time, which many of us know as Great Recession of late 2000s.
Why Corporate Failure Occurs?
Corporate failure may occur due to various reasons, such as:
- Poor or no corporate structure and governance;
- Failure to conduct continuous risk assessment, inability to identify and assess risk and devising suitable and timely remedy;
- Poor financing structure, resulting in high gearing, overtrading, over/ under capitalization and working capital problems;
- Inability to innovate product and services offered for long periods;
- Incapacity to respond to technological and scientific advancement;
- Inability to enter into new markets or attract new market segments;
- Poor management team and its lack of oversight, control and involvement in fraudulent activity;
- Inability to attract and retain management and staff with certain level of skills and competence at key positions or its active turnover;
- Major lawsuit, resulting in loss of reputation and compensations and penalties;
- Adverse public and fiscal/ monetary policy by the government, such as enhanced tariffs, taxes, duties and reduced wage levels etc., affecting overall economic condition;
- Overdependence on few suppliers, customers and related industries.
How to Identify a Destined Corporate Failure?
Corporate failure normally do not occur overnight, but various events either in isolation or in conjunction of each other, must be taking place for quite some time, which would indicate that the situation is worsening and must be managed before a collapse is inevitable:
- Adverse public opinion and media coverage/ reporting;
- Major court decision against the entity, resulting in probable outflow of profligate funds to settle the dispute;
- Inability to reschedule and refinance borrowing limits and utilizing borrowing to its full capacity;
- Low profitability/ piling up of losses, worsening gearing, investors and other financial ratios, which further indicate possible cash flow issues in future;
- Failure to raise further long term finance and default on major covenants;
- Early maturity and termination/ withdrawal of major long term investments;
- A major product/ service line going out of the market with no readily available alternate;
- Reduced market share in a competitive market;
- Key personnel(s) leaving employment with entity frequently and inability to find suitable replacement;
- Disputes and conflicts among board members/ corporate directors and between management team;
- Failure or cessation of business of major supplier, customer or recession and sharp decline in demand for products of related industry;
- Adverse opinion by independent internal and external auditors, highlighting fraudulent and deceitful affairs of business taking place and perpetual pattern of unwillingness by those charged with governance to address the situation.
How to Avoid Corporate Failure?
Most of the causes and indicators of any corporate failure can be managed beforehand, before a misfortune is certain:
- Improved corporate structure and governance system through introduction of Audit committee, Finance committee and Risk committee having independent directors and members from relevant educational and professional background;
- Continuous risk assessment and devising suitable and timely remedy;
- Financing structure as per the optimum need of the entity, which could reduce financial risk and improve profitability and financial ratios;
- Suitable and timely measures to fix business risk;
- Innovation in product design and services offered on timely and frequent basis to maintain and attain sustainable competitive advantage;
- Timely and optimum response to technological and scientific advancements;
- Product and market development strategies through product development and market development to enhance overall market share;
- Acquisition and mergers with competitors to thwart them off from securing market share;
- Hiring of active/ motivated management team with strong oversight, control and insight of business operations and its conduct;
- Policy to hire and retain management and staff with certain level of skill and competence at key positions and their continuous technical and professional development;
- Adherence to laws and regulation, to enhance reputation in public eye, improved media coverage and minimizing the risk of loss of reputation, litigation claims and penalties;
- Reducing the overdependence on narrow line of suppliers, customers and related industries through vertical integration, either forward, backward or both, especially in a monopolized economy.
Takeaways from this Blog
Corporate failure may occur due to various factors, both internal and external either within or outside an entity’s control. However, whenever it occurs it is deemed to exert destructive impact on both local and international economic and social environments. Nevertheless, appropriate and timely identification and mitigation strategy could possibly fend off the catastrophe it may bring to us all living in this small world.
Agha Mudassar Khan
Associate Chartered Certified Accountant
Senior Manager Taxation and Advisory Services