Financial Failure in Business – A Case Study on How it Went Terribly Wrong

Introduction

Financial failure is the rule rather than the exception in entrepreneurial ventures. Even in well-established businesses the occurrence thereof is alarming. A multitude of reasons for financial failure exist. Sometimes these factors are beyond the reach of management, but most of the times they could have been foreseen and prevented.

Over more than a decade we advised and assisted companies in growing and managing their businesses. This case study highlights the importance of proper financial planning and the management of the various financial issues. It shows a real-life example of how many factors culminated in financial disaster.

Why Did This Company Fail?

It is normally several factors that cause the financial downfall of a company. By analyzing the failure of a company a storyline presents itself with a thread that runs through the various mistakes. We analysed this medium-sized company’s figures on behalf of the shareholders and the company’s biggest supplier. By that time the company was already in financial ruin. The main causes for this failure can be summarised as follows:

• Financial Acumen. The problems within the company started when managers were appointed with a lack of experience and financial acumen.
• Financial Planning. No financial planning was done – not even cashflow projections. Everybody was measured on sales.
• Gross Profits. The gross margins were on average 3.3% over the last three years. This is extremely low in an industry that operates around 20% margins.
• Sales. The rationale behind the low gross margins was to get sales – at all costs. In the beginning the sales went up to $135 million (from $58 million) and this gave them around 35% of the market share (in their niche market). At that levels they could not afford to properly service the clients and during the last year sales drop to $91 million.
• Expenditure. During this time of crisis operating expenses increased from 2.9% to 5.7% – substantially above the 3.3% gross profit. This was a recipe for financial disaster. Increases in expenses were mainly due to conference costs, salaries, entertainment and products that were just given away.
• Debtors. Management decided to slacken their credit policy to assist the sales. They also did not want to offend their clients and were very lenient with collections. The net effect was that accounts receivable went from an already bad 66.8 days to 93.4 days. Bad debts increased from 0% to 0.8%.
• Inventory. Stock holding was more or less constant at 43.6 days. The average in the industry is around 30 days. Management bought extra stock at discounted prices. Unfortunately most of these stock items were not excellent sellers.
• Debt. The debt to equity ratio changed over time from 15.4:1 to 28.9:1. The accounts payable (creditors) were paid on 211 days on average – up from 147.8 days. The industry norm is 90 days. Interest costs worsen the problems and increased from $644,000 to $1.81 million during the last two years.

The cumulative effects of these problems were devastating. The ratios were extremely bad. The company was not profitable, liquid or solvent. No investor or bank was prepared to put anything into the company. 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 This All Be Prevented?

The company’s problems really started when they restructured and appointed shareholders in the key management positions. These people did not have the necessary business- and financial acumen. They were also given a free reign and this created attitude-, ethical- and corporate governance concerns. By the time that the situation was investigated it was already too late.

In addition to the appointment of the right qualified people (with a much lower salary bill at market-related remunerations), a few changes could have made a big difference:

• Financial Planning. Professionally managed cashflows 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 too high expenses are guaranteed financial suicide.
• Gross Profits and Sales. By targeting gross margins in the region of 20% and by keeping their service levels as before the company should have sustained there previous sales (around $58 million). This would give them a gross profit of $11.6 million (compared to about $3 million currently) – more than enough to cover expenses, provide for growth and bringing their financial ratios to acceptable levels.
• Expenditure. By keeping salaries market related, by curtailing entertainment and conference costs and by not giving products away the company could have easily saved another $1.5 million per year.

In addition to the above the inventory holding (stock) and debtor days (accounts receivable) could have substantially be improved. The accounts payable were, however, in such a bad situation that drastic changes were necessary. The effect of these changes would mean another $3.5 million was needed as working capital. The net effect of all these changes in the company would have been a surplus cash of around $4.6 million. This was enough to service the company’s interest commitments, improve its ratios and to steadily grow the business.

Summary

It is seldom just one issue that causes the financial failure of a company. Sometimes apparent small changes are necessary to increase the chances of financial success in a business. It is important for management to gain the necessary financial acumen, to plan properly, to monitor the financial performance diligently (especially against cashflows) and to take corrective actions where needed (preferably pro-actively).

Copyright© 2008 – Wim Venter