The components of Corporation Financing in the Economy - Free Essay Example

Sample details Pages: 9 Words: 2615 Downloads: 1 Date added: 2017/06/26 Category Business Essay Type Research paper Did you like this example? The major issue arising in the present times, for both management academics and practitioners, relates to the principles which determine corporate successes and failures that is why some organization prosper and grow while other collapse. The often unexpected collapse of large companies during the early 1990s and more recently in 2002 has lead analysts to look for ways of predicting company failure. Corporate failures are common in competitive business environment where market discipline ensures the survival of fittest. Don’t waste time! Our writers will create an original "The components of Corporation Financing in the Economy" essay for you Create order Moreover, mismanagement also leads to corporate failure. Predicting corporate failure is based on the premise that there are identifiable patterns or symptoms consistent for all failed firms. Definition According to Altman (1993), there is no unique definition of 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. COPORATE FAILURE The models to predict Corporate Failure: Several techniques have been developed to help predict why companies fail. However, these are not accurate and doo not guarantee that the prediction will turn out to be true. These models are The Z-Score, Argenti Model, and the VK model amongst others. Beaver was one of the first researchers to study the prediction of bankruptcy using financial statement data. The established practice for failure prediction is therefore a model based on financial ratio analysis. Published financial reports contain a great deal of information about the company performance and prospects. Therefore, ratio analysis is not preferred for financial accounts interpretation however; it has also played a central role in the development of bankruptcy prediction models. The Altman Model: Z-Score The Z-Score model is a quantitative model developed by Edward Altman, a financial economist and professor at the Leonard N.Stern School of business at New York University in 1968 to predict bankruptcy or fi nancial distress of a business. The Z-score is a multi variate formula that measures the financial health of a company and predicts the probability of bankruptcy within 2 years. This model involves the use of a specified set of financial ratios and a statistical method known as a Multiple Discriminant Analysis. (MDA). The real world application of the Altman score successfully predicted 72% of bankruptcies two years prior to their failure. The model of Altman is based on a linear analysis in which five measures are objectively weighted and summed to arrive at an overall score that then becomes the basis for classification of companies into one of the two a priori groupings that is bankrupt or non- bankrupt. These five indicators were then used to derive a Z-Score. These ratios can be obtained from corporations financial statements. COPORATE FAILURE The five Z-score constituent ratios are: 1. Working Capital/Total Assets (WC/TA):- a firm with negative working capital i s likely to experience problems meeting its short-term obligations. 2. Retained Earnings/Total Assets: Companies with this ratio high probably have a history of profitability and the ability to stand up to a bad year of losses. 3. Earnings Before Interest Tax/ Total Assets: An effective way of assessing a firms ability to profit from its assets before things like interest and tax are deducted. 4. Market Value of Equity/ Total Liabilities: A ratio that shows, if a firm were to become insolvent, how much the companys market value would decline before liabilities exceed assets. 5. Sales/Total Assets: A measure of how management handles competition and how efficiently the firm uses assets to generate sales. Based on the Multiple Discriminant Analysis, the general model can be described in the following form: Z=1.2WC/TA + 1.4 RE/TE + 33 EBIT/TA + 0.6 MVE/TL + 1.0 SL/TA Altman (1968) found that companies having a Z-Score greater than 2.99 clearly f ell into the non- bankrupt category, while companies having a Z-Score below 1.81 were all bankrupt. The area between 1.81 and 2.99 was defined as the zone of ignorance because of the susceptibility to inaccurate classification. Z-Score Probability of Failure Less than 1.8 very High Greater that 1.81 but less than 2.99 Not Sure Greater than 3.0 Unlikely Calculation of the Z-Score for a fictitious company where the different values are given to calculate the Z-Score. Sales 25,678 Total Assets 49,579 Total liabilities 5,044 Retained earnings 177 Working Capital -1,777 Earnings before interest and tax 2,605 Market value of Equity 10,098 Book value of Total Liabilities A Type 1 failure characterises the failure of newly formed and therefore mainly small companies. Whereas, Type 2 is characterised by the presence of a very ambitious, charismatic and active manager with an outstanding personality. Due to his over ambition the company is brought down. These failure types can occur to young organisations, but they usually survive longer than Type1 companies. Type 3 failures only occur to mature companies that have been operating successful over a fair number of years and that often are of a major social and economic importance to the community. The largest characteristic of Type 3 companies is its insensitivity towards changes in the environment, whereas the world around it is changing with its environment. Symptoms of corporate failure There are three classic symptoms of corporate failure. These are namely: 1. Low profitability 2. High gearing 3. Low liquidity Each of these three symptoms may be indicated by trends in the companys accounts. Symptoms are interrelated. The classic path to corporate failure starts with the company experiencing low profitability. This may be indicated by trends in the ratios for: ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Profit margin ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Return on Capital Expenditure ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Return on Net Assets A downward trend in profitability will raise the issue of whether and for how long the company can tolerate a return on capital that is below its cost of capital. If profitability problems become preoccupying, the failing of the company may seek additional funds and working capital by increasing its borrowings, whether in the form of short term or long-term debt. This increases the companys gearing, since the higher the proportion of borrowed funds, the higher the gearing within the capital structure. The increased debt burden may then aggravate the situation, particularly if the causes of the decreasing profitability have not been resolved. The worsening profit situation must be used to finance an increased burden of interest and capital repayments. In the case of a publicly quoted company, this means that fewer and fewer funds will be available to finance dividend payments. It may become impossible to obtain external credit or to raise further equity funds. Confidence in the company as an investment may wither away leaving the share price to collapse. If the company is sound, for instance, but ineptly managed, the best that can be hoped for is a takeover bid for what may be now a significantly undervalued investment. At this point, a company may not be really failing but unfortunately, more often rescue attempts are not mounted. This may be because the companys management does not recognize the seriousness of the situation, or is by now too heavily committed or too frightened to admit the truth to its stakeholders, when refinancing is attempted profits fail to cover payments leading to a cash flow crisis. CAUSES OF CORPORATE FAILURE AND THEIR EXAMPLES: Technological causes Traditional methods of doing work have been turned upside down by the development of new technology. If within an industry, there is failure to exploit information technology and new production technology, the firms can face serious problems and ultimately fail. By using new technology, cost of production can be reduced and if an organization continues to use the old technology and its competitors start using the new technology; this can be detrimental to that organization. Due to high cost of production, it will have to sell its products at higher prices than its competitors and this will consequently reduced its sales and the organization can serious problems This situation was seen in the case of Mittal Steel Company taking over Arcelor Steel Company. Arcelor Steel Company was using its old technology to make steel while Mittal Steel Company was using the new technology and as a result, Mittal Steel Company was able to sell steel at lower price than Arcelor Steel Company d ue to its low cost of production. Arcelor Steel Company was approaching corporate failure and luckily, Mittal Steel Company merged with Arcelor Steel Company and became ArcelorMittal Steel Company, thus preventing Arcelor from failure. Working capital problems Organizations also face liquidity problems when they are in financial distress. Poor liquidity becomes apparent through the changes in the working capital of the organization as they have insufficient funds to manage their daily expenses. Businesses, which rely only on one large customer or a few major customers, can face severe problems and this can be detrimental to the businesses. Losing such a customer can cause big problems and have negative impact on the cash flows of the businesses Economic distress 7 COPORATE FAILURE A turndown in an economy can lead to corporate failures across a number of businesses. The level of activity will be reduced, thus affecting negatively the performance of firms in several industries. This cannot be avoided by businesses. The recent economic crisis in the USA led to many cases of corporate failures. One of them is the insurance AIG insurance company. It is facing serious problems and it might close its door in the near future. COPORATE FAILURE MISMANAGEMENT Inadequate internal management control or lack of managerial skills and experience is the cause of the majority of company failures. Some managers may lack strategic capability i.e. to recognize strengths, weaknesses, opportunities and threats of a given business environment. These managers tend to take poor decisions, which may have bad consequences afterwards. Furthermore, managers of different department may not have the ability to work closely together. There are dispersed department objectives, each department will work for their own benefits not towards the goal of the company. This will bring failure in the company. One example can be WorldCom, where the finance and legal functions were scattered over several states and communication between these departments were poor. OVER-EXPANSION AND DIVERSIFICATION Research has shown that dominant CEO is driven by the ultimate need to succeed for their own personal benefits. They neglect the objective set for the company and work for their self- interest. They want to achieve rapid growth of the company to increase their status and pay level. They may do so by acquisition and expansion. The situation of over expansion may arise to the point that little focus is given to the core business and this can be harmful as the business may become fragment and unfocused. In addition, the companies may not understand the new business field. Enron and WorldCom can be an example for this situation where the managers did not understand how growing overcapacity would influence its investment and therefore did not comprehend the risks associated with it. FRAUD BY MANAGEMENT Management fraud is another factor responsible for corporate collapse. Ambitious managers may be influenced by personal greed. They manipulate financial statements and accounting reports. Managers are only interested in their pay checks and would make large increase in executive pay despite the fact that the company is facing poor financial situation. Dishonest managers will attempt to tamper and falsify business records in order to fool shareholders about the true financial situation of the company. These fraudulent acts or misconduct could indicate a serious lack of control. These frauds can lead to serious consequences: loss of revenue, damage to credibility of the company, increased in operating expenses and decrease in operational efficiency. POORLY STRUCTURED BOARD Board of Directors is handpicked by CEO to be docile and they are encouraged by executive pay and generous benefits. These directors often lack the necessary competence and may not control business matters properly. These directors are often intimated by dominant CEO and do not have any say in decision making. Example Enron and WorldCom where poorly structured board was a contributor towards their failure Financial distress Firms that become financially distressed are found to be under- performing relative to the other companies in their industry. Corporate failure is a process rooted in the management defects, resulting in poor decisions, leading to financial deterioration and finally corporate collapse. Financial distresses include the following reasons also low and declining profitability, investment Appraisal, Research and Development and technical insolvency amongst others. A firm may fail, as its returns are negative or low. A firm that consistently reports operating losses probably experiences a decline in market value. If the firm fails to earn a return greater than its cost of capital, it can be viewed as having failed. Falling profits have an obvious link with both financial and bankruptcy as the firm finds it is not generating enough money to meet its obligations as they fall due. Political and legal causes also can affect organisations. New legislation for example on product safety s tandards or pollution controls, can affect a companys main products. The imposition of a complete ban on an organisations product might be damaging and lead the firm to loses. The Tobacco industries are at present faced with the prospect of a ban on advertising for their product. Another cause that will lead the company to fail is the investment appraisal. Many organizations run into difficulties as they fail to appraise investment projects carefully. The long- term nature of many projects means that outcomes are difficult to forecast and probabilities are usually subjective. Big project gone wrong is a common cause of decline. For example the acquisition of a loser company. This has happen in the case for the failure of Parmalat Co Ltd of Italy, which made the acquisition of several losses making company. Inappropriate evaluation of the acquired company, its strengths and weaknesses. COPORATE FAILURE Preventing corporate failures It is a fact that some companies perform well and that some underperform and some fails. In many, if not most cases, these companies are led by executives that are quite experienced. Below are some recommendations that can help to reduce the risk of failures of organisations: Appointment of non-executive directors The non-executive directors will bring their special expertise and knowledge on strategies, innovative ideas and business planning of the organization. They will monitor the work of the executive management and will help to resolve situations where conflict of interest arises. Overall, the non-executive directors will act as a Cross Check. Audit committees Very often, there is occurrence of fraud in management and financial reporting. The presence of the audit committees will help to resolve this problem. Audit committees have the potential to reduce the occurrence of fraud by creating an environment where there is both discipline and control. Code of ethics Corporate governance is based on enterprise and integrity. Directors of companies need to do their jobs with good faith and in the interest of the company. There must be a relationship of honesty, openness and fairness between the stakeholders. Development of environment learning mechanism Some organizations fail because they lose touch with their environment. Therefore, to counter this problem, there is a need to develop the environmental learning mechanism. Through it, new information can be brought on continuous basis. This is mainly done by carrying customer- feedback surveys. In this way, the organisation can realign itself with the new needs and challenges. Focus on research and development Organizations can generate new knowledge by investing and focusing more on research and development. Thus, there will be more ideas how to make the products much better than that of their competitors. Conclusion It can be deducted that a director has a big responsibility that he has to assume The recommendations mentioned above can help directors to reduce corporate failure, provided that the directors abide. Proper planning also is critical to the success of a business.