Introduction
Financial failure is the rule rather than the exception in business ventures. Even in well-established businesses, its occurrence is alarming. There are a multitude of reasons for financial failure. Sometimes these factors are beyond the scope of management, but most of the time they could have been anticipated and prevented.
For more than a decade we have been advising and helping companies grow and manage their businesses. This case study highlights the importance of proper financial planning and management of various financial problems. Show a real-life example of how many factors led to a financial disaster.
Why did this company fail?
Normally there are several factors that cause the financial decline of a company. When analyzing the failure of a company, a story is presented with a thread that runs through the various errors. We analyze the figures 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 were appointed with a lack of experience and financial acumen.
- Financial planning. No financial planning was done, not even cash flow projections. Everyone was measured in sales.
- Gross profit. Gross margins averaged 3.3% over the last three years. This is extremely low in an industry that operates with margins of around 20%.
- Dirty. The reason for the low gross margins was to get sales, at all costs. Initially, sales went 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 last year sales fell to $ 91 million.
- Spending. During this time of crisis, operating expenses increased from 2.9% to 5.7%, substantially above gross profit of 3.3%. This was a recipe for financial disaster. The increases in expenses were primarily due to the costs of conferences, salaries, entertainment, and newly gifted 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 collections. The net effect was that accounts receivable went from a 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 inventory at reduced prices. Unfortunately, most of these in-stock items weren’t great sellers.
- Debt. The debt-to-equity ratio changed over time from 15.4: 1 to 28.9: 1. Accounts payable (creditors) were paid in 211 days on average, compared to 147.8 days. The industry standard is 90 days. Interest costs compounded the problems, 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 contribute anything to the company. Creditors took legal action and a once healthy (but smaller) company was destroyed and liquidated less than five years after the new administration took over.
How could all this be prevented?
The company’s problems really started when they restructured and appointed shareholders in key management positions. These people did not have the necessary business and financial acumen. They were also given free rein, and this created attitude, ethics and corporate governance concerns. When the situation was investigated, it was too late.
In addition to appointing the right qualified individuals (with a much lower pay bill in 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 applied. Financial planning would also have shown that the path of too low gross margins and too high expenses is guaranteed financial suicide.
- Gross profit 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 approximately $ 3 million currently), more than enough to cover expenses, provide growth and bring their financial ratios to acceptable levels.
- Spending. By keeping wages related to the market, by cutting entertainment and conference costs, and by not giving away products, the company could easily have saved another $ 1.5 million a year.
In addition to the above, inventory holding (stock) and debit days (accounts receivable) could have been substantially improved. However, accounts payable 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 company 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
It is seldom a single problem that causes the financial failure of a business. Sometimes seemingly small changes are necessary to increase the chances of financial success in a company. It is important for management to acquire the necessary financial acumen, plan appropriately, monitor financial performance diligently (especially against cash flows), and take corrective action when necessary (preferably proactively).
Copyright © 2008 – Wim Venter