Introduction
Financial failure is the rule and not the exception in business ventures. Even in well-established businesses, their occurrence is alarming. There are a multitude of reasons for financial failure. Sometimes these factors are beyond the reach of management, but more often than not they could have been foreseen and prevented.
For more than a decade we have advised and assisted companies in the growth and management of their businesses. This case study highlights the importance of proper financial planning and management of various financial problems. It shows a real life example of how many factors culminated in a financial disaster.
Why did this company fail?
Normally there are several factors that cause the financial fall of a company. When analyzing the failure of a company, a story is presented with a thread that runs through the various mistakes. We looked at the numbers for this midsize company on behalf of the shareholders and the company’s largest supplier. At that time the company was already in financial ruin. The main causes of this failure can be summarized as follows:
- Financial acumen. The problems within the company began when managers with a lack of experience and financial acumen were appointed.
- Financial planning. No financial planning was done, not even cash flow projections. Everyone was measured on sales.
- Big benefits. Gross margins averaged 3.3% over the last three years. This is extremely low in an industry that operates on margins of around 20%.
- Dirty. The reason behind the low gross margins was to get sales, at all costs. Early on, sales were up to $135 million (from $58 million) and this gave them about 35% of the market share (in their niche). At those levels, they couldn’t afford to adequately serve customers, and over the past year sales have fallen to $91 million.
- Spent. During this time of crisis, operating expenses increased from 2.9% to 5.7%, substantially above the 3.3% of gross profit. This was a recipe for financial disaster. The increases in expenses were mainly due to the costs of conferences, salaries, entertainment and newly given away products.
- debtors Management decided to relax its credit policy to help sales. They also did not want to offend their customers and were very lenient with the charges. The net effect was that accounts receivable went from 66.8 bad days to 93.4 days. Bad debts increased from 0% to 0.8%.
- Inventory. Stock holding was roughly constant at 43.6 days. The industry average is around 30 days. Management bought additional shares at reduced prices. Unfortunately, most of these in-stock items were not great sellers.
- debt. The debt to equity ratio changed over time from 15.4:1 to 28.9:1. Accounts payable (creditors) were paid on average 211 days, compared to 147.8 days. The industry standard is 90 days. Interest costs made the problems worse, rising from $644,000 to $1.81 million over the past two years.
The cumulative effects of these problems were devastating. The proportions were extremely bad. The company was not profitable, neither liquid nor solvent. No investor or bank was willing to invest anything in the company. Creditors took legal action, and a once thriving (but smaller) company was destroyed and liquidated in less than five years after new management took over.
How could all this be prevented?
The company’s problems really began when it restructured and appointed shareholders to key management positions. These people did not have the necessary business and financial acumen. They were also given free rein and this raised concerns about attitude, ethics and corporate governance. By the time the situation was investigated it was already too late.
In addition to the appointment of the right qualified people (with a much lower wage bill with market-related compensation), 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 taken. Financial planning would also have shown that the path of gross margins that are too low and expenses that are too high is guaranteed financial suicide.
- Gross Profits and Sales. By targeting gross margins in the region of 20% and keeping its service levels as before, the company should have sustained its previous sales (around $58 million). This would give them a gross profit of $11.6 million (compared to $3 million today), more than enough to break even, provide growth, and bring their financial ratios to acceptable levels.
- Spent. By keeping salaries market-related, cutting entertainment and speaking costs, and not giving away product, the company could have easily saved another $1.5 million per year.
In addition to the above, inventory holdings (stock) and days debtors (accounts receivable) could have improved substantially. Accounts payable was, however, in such bad shape that drastic changes were necessary. The effect of these changes would mean that another $3.5 million would be needed as working capital. The net effect of all these changes on the company would have been a cash surplus of about $4.6 million. This was enough to meet the interest commitments of the company, improve its indexes and grow the business constantly.
Resume
It is rarely just one problem that causes a company to fail financially. Sometimes small apparent changes are necessary to increase the chances of financial success in a business. It is important that management acquire the necessary financial acumen, plan appropriately, monitor financial performance diligently (especially in relation to cash flows), and take corrective action when necessary (preferably proactively).
Copyright © 2008 – Wim Venter