Financial failure is the rule rather than the exception in entrepreneurs. Even in well-established companies, the incidence is alarming. There are a number of causes of financial failure. Sometimes these factors are beyond the reach of management, but most of the times they could have been foreseen and prevented.
For more than a decade, we advised and helped businesses grow and manage their businesses. This case study highlights the importance of proper financial planning and management of the various financial issues. It shows a true example of how many factors culminated in a financial disaster.
Why did this company fail?
It is usually several factors that cause a company’s financial downfall. By analyzing a company’s failure, a story line presents itself with a thread that runs through the various flaws. We analyzed the figures of this medium-sized company on behalf of the shareholders and the company’s largest supplier. By then, the company was already in financial ruin. The main causes of this failure can be summarized as follows:
- Financial acuity. The company’s problems began when executives were appointed with inexperience and financial acumen.
- Financial planning. No financial planning was done – not even cash flow forecasts. All were measured on sales.
- Gross profit. Gross margins averaged 3.3% over the last three years. This is extremely low in an industry that operates around 20% margins.
- You go out. The rationale behind the low gross margins was to get sales – at all costs. Initially, sales rose to $ 135 million (from $ 58 million), giving them around 35% of their market share (in their niche market). At that level, they could not afford to service the clients properly, and over the past year sales dropped to $ 91 million.
- Expenses. During this time of crisis, operating expenses increased from 2.9% to 5.7% – substantially above 3.3% gross profit. This was a recipe for financial disaster. Increases in expenses were mainly due to conference costs, salaries, entertainment and products just given away.
- Debtors. Management decided to ease their credit policy to help sales. They also did not want to offend their clients and were very gentle with rallies. The net effect was that receivables from receivables went from an already bad 66.8 days to 93.4 days. Bad debt increased from 0% to 0.8%.
- Inventory. The stock was more or less constant at 43.6 days. The industry average is about 30 days. Management bought additional shares at reduced prices. Unfortunately, most of these stock items were not excellent sellers.
- Debt. Debt to equity ratio changed over time from 15.4: 1 to 28.9: 1. The paid accounts (creditors) were paid on average 211 days – up from 147.8 days. The industry standard is 90 days. Interest costs exacerbated the problems, rising from $ 644,000 to $ 1.81 million over the past two years.
The cumulative effects of these problems were devastating. Conditions were extremely bad. The company was not profitable, liquid or solvent. No investor or bank was prepared to put anything into the business. The creditors took legal action and a once healthy (but smaller) company was destroyed and liquidated within less than five years after the new management took over.
How could all this be prevented?
The company’s problems really began as they restructured and appointed shareholders in key management positions. These people did not have the necessary business and financial acumen. They were also given a free reign and this created attitudinal, ethical and corporate governance concerns. When the situation was investigated, it was already too late.
In addition to appointing the right qualified people (with a much lower salary bill for market-related remuneration), a few changes could have made a big difference:
- Financial planning. Professionally managed cash flows could have indicated where potential problems lie and corrective actions could have been applied. Financial planning would also have shown that the path of too low gross margins and excessive spending guarantees financial suicide.
- Gross profit and sales. By targeting gross margins in the region of 20% and keeping their service levels as before, the company should have maintained its previous sales (approximately $ 58 million). This would give them a gross profit of $ 11.6 million (compared to about $ 3 million at the moment) – more than enough to cover expenses, provide growth and bring their financial conditions to an acceptable level.
- Expenses. By keeping the payroll market related, by limiting entertainment and conference costs, and by not giving away products, the company could easily have saved an additional $ 1.5 million a year.
In addition to the above, inventory (inventory) and debtor days (receivables) could have been significantly improved. However, the payments were in such a bad situation that drastic changes were needed. The effect of these changes would require an additional $ 3.5 million in working capital. The net effect of all these changes in the business would have been a surplus cash holding of about $ 4.6 million. This was sufficient to serve the company’s interest obligations, improve its relationship and to grow its business continuously.
Rarely is it just a matter of causing a company’s financial failure. Sometimes, seemingly small changes are needed to increase the chances of financial success in a business. It is important for management to achieve the necessary financial acumen, to plan properly, to closely monitor economic development (especially against cash flows) and, if necessary, take corrective action (preferably proactively).
Copyright © 2008 – Wim Venter