Financial Failure in Business: A Case Study of How It Gone Horribly Wrong

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 most of the time 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 managing various financial issues. It shows a real life example of how many factors culminated in 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 analyze the figures of this medium-sized 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. 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 in sales.
• Big benefits. Gross margins averaged 3.3% in 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 win sales, at all costs. Sales initially jumped to $135 million (from $58 million) and this gave them about 35% market share (in their niche). At those levels, they couldn’t afford to serve customers properly, and over the last year sales fell 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 conference costs, salaries, entertainment and newly given away products.
• debtors Management decided to relax its credit policy to help sales. They also didn’t want to offend their customers and were very lenient with their charges. 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 holdings were more or less constant at 43.6 days. The industry average is around 30 days. Management purchased 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 norm is 90 days. Interest costs made the problems worse, rising from $644,000 to $1.81 million over the last 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 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 created concerns about attitude, ethics and corporate governance. By the time the situation was investigated it was already too late.

Aside from appointing the right qualified people (with a much lower wage bill with market-related pay), 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 maintaining 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 cover expenses, provide growth and bring their financial ratios to acceptable levels.
• Spent. By maintaining market-related salaries, reducing entertainment and speaking costs, and not giving away products, the company could have easily saved another $1.5 million per year.

In addition to the above, inventory holding (stock) and debit days (accounts receivable) could have improved substantially. Accounts payable, however, were 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 business would have been a cash surplus of about $4.6 million. This was enough to meet the company’s interest commitments, improve its ratios and grow the business steadily.

Summary

Rarely is it just one problem that causes a business to fail financially. Sometimes small apparent changes are necessary to increase the chances of financial success in a business. It is important for management to acquire the necessary financial acumen, plan properly, monitor financial performance diligently (especially in relation to cash flows), and take corrective action when necessary (preferably proactively).

Copyright© 2008 – Wim Venter