ch13 ppt rankin

Chapter 13Corporate Failure

PowerPoint Presentation by Matthew Tilling

©2012 John Wiley & Sons Australia Ltd

WHAT IS CORPORATE FAILURE?

• Corporate failure is difficult to define.• Often referred to a bankruptcy or insolvency.– Also sometimes terms failure or default.

• In research the point of failure can be considered to be:– Filing for bankruptcy– Delisiting for whatever reason– Ceasing to trade– Entering into receivership


• A significant indication of corporate failure could be the appointment of voluntary administrators.– In the US this is called Chapter 11 bankruptcy– In Australia can be initiated by directors or secured

creditors• It entails the appointment of an administrator

who– Investigates the affairs of the company.– Tries to find a way to save the business.


• Dunn & Bradstreet, a global entity that researches business failures adopts a wide definition of business failure:businesses that cease operation following assignment or bankruptcy; those that cease with loss to creditors after such actions or execution, foreclosure, or attachment; those that voluntarily withdraw, leaving unpaid obligations, or those that have been involved in court actions such as receivership, bankruptcy reorganization, or arrangement; and those that voluntarily compromise with creditors.

CAUSES OF CORPORATE FAILURE

• There are many reasons why companies fail.• Most fail for multiple reasons.• Corporate decline can stem from multiple

sources both inside and outside the organisation.

• These multiple elements often make it difficult for managers to comprehend and address the causes of corporate failure.


• Outside factors can include: – Changes in technology – Recession– Competitors’ actions– Deregulation or changes in import protection in an

industry– Interest rate changes


• Inside factors can include: – Weak strategy– Financial mismanagement,– Dysfunctional culture


• While there are many factors that can contribute to corporate failure, research of some high profile failures has identified specific management inadequacies that appear to contribute significantly.

• Prominent corporate failures include– Enron, HIH, Barings Bank, WorldCom, ABC

Learning, Tyco and Parmalat.


• Hamilton and Micklethwait believe that the main causes of failure can be grouped into six categories:1. Poor strategic decisions. 2. Greed and the desire for power. 3. Overexpansion and ill-judged acquisitions. 4. Dominant CEOs. 5. Failure of internal controls. 6. Ineffective boards.


• The role of cash flow has been noted by a number of observers.

• There needs to be enough cash to pay staff, GST obligations, debtors and other operational expenses.

• Businesses are more likely to fail because of poor cash flow than poor sales.

COSTS OF FAILURE

• Direct costs include – Expenses to hire various professionals– Additional interest on holding debt that cannot be

discharged• Indirect costs are more difficult to identify, but

may include– Reputation costs– Opportunity costs

PREDICTING CORPORATE FAILURE

• A range of methods have been used to assess corporate financial performance and to search for signs of financial distress.– Ratio Approach• Liquidity• Profitability

– Bankruptcy prediction models• Altman’s Z-Score is one of the best known


Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Z = Overall Index or ScoreX1 = Working Capital/Total AssetsX2 = Retained Earnings/Total AssetsX3 = Earnings before Interest and Tax/Total AssetsX4 = Market Value of Equity/Book Value of Total LiabilitiesX5 = Sales/Total Assets

• A Z-Score of 3.0 or more is healthy.• A score of 1.8 to 2.9 is in the ‘danger zone’.• A score below 1.8 indicates a high probability of failure.


• Studies have shown that Altman’s Z-Score has validity in assessing Australian companies.

• A variety of other models have been developed– Though most simply refine Altman’s original work.– One such model is the CAMEL (Capital adequacy,

Asset and Management quality, Earnings, Liquidity) mode.

INDICATORS OF CORPORATE FAILURE

• The Australian Securities and Investments Commission (ASIC) has set up the National Insolvent Trading Program, which aims to:– Make directors aware of their company’s financial

position.– Make directors of potentially insolvent companies

aware of their responsibilities. – Encourage directors to seek external advice from

accountants, lawyers and insolvency professionals.

INDICATORS OF CORPORATE FAILURE

• ASIC has identified some key operational and financial practices which, in combination with other practices, indicate a company is at significant risk of insolvency. Some include:– Poor cash flow, or no cash flow forecasts– Disorganised internal accounting procedures– Absence of budgets and corporate plans– Continued loss-making activity– Accumulating debt and excess liabilities over assets– Loss of key management personnel

CORPORATE GOVERNANCE ISSUES

• Corporate governance practices are often at the heart of corporate failure.

• Corporate governance relates to the ‘duties and responsibilities of a company’s board of directors in managing the company and their relationships with the shareholders of the company and the stakeholder groups’


• Strong corporate governance, at a company level, will have the following characteristics:– Boards are active in setting and approving the

strategic direction of the company.– Boards are effective in overseeing risk and setting

an appropriate risk level for the entity.


• BusinessWeek annually rates boards on their corporate governance. The principles of good governance they look for include:1. Independence.2. Stock ownership.3. Director quality.4. Board activism.

REGULATION AND POLITICAL RESPONSES TO CORPORATE FAILURE• Significant corporate failure has consistently led

to a focus on corporate governance and a demand for corporate reform.

• In Australia, corporate failures in the 1980s were thought to result from inadequate accounting disclosures.

• Perceived limitations in corporate governance legislation that led to the collapse of Enron, led to the US’s Sarbanes-Oxley Act in 2002.

REGULATION AND POLITICAL RESPONSES TO CORPORATE FAILURE• Subsequent corporate failures in Australia have

been used to justify:– The Financial Reporting Council introduced

International Accounting Standards from 1 January 2005.

– Establishment of the ASX Corporate Governance Council and publishing best practice corporate governance guidelines for listed companies in 2003.

– The Corporate Law Economic Reform Program

THE ANATOMY OF A CORPORATE FAILURE

• There is often not one indicator that a company is likely to become distressed or fail.

• Cash flow has been seen to be a major contributing factor to corporate failure.– This is particularly evident in the retail sector.

• Deficiencies in the audit process have been found to play a role in a number of collapses.– These can be compounded by conflicts of interest.

THE ANATOMY OF A CORPORATE FAILURE

• Other factors include– Lack of independence of the audit committee.– Ownership structure dominated by a single

shareholder.– Lower than average proportion of the

remuneration package for CEO ‘at risk’.– Significant related party transactions.

A CASE STUDY: THE GLOBAL FINANCIAL CRISIS

Causes and consequences of the GFC– The GFC is said to have started in the US housing

sector.– Leading up to the financial crisis there were• Substantial increase in housing prices• Historically low interest rates• Subprime mortgages increasingly being used

– This created an asset bubble

Causes and Consequences of the GFC

• Towards the end of 2006 house prices started declining, with significant defaults and foreclosures on mortgages following in early 2007.

• This quickly turned into a financial crisis which affected credit markets and jeopardised the banking system.

• The financial and economic effects of the GFC were then transferred to other countries.

Government intervention in the GFC

• Both the Australian and New Zealand governments responded to the GFC by announcing stimulus packages to ‘kick start’ the economy and to avoid a full recession.

• The health of Australian Authorised Deposit-taking Institutions (ADIs) following the GFC, as a result of regulation by the Australian Prudential Regulatory Authority (APRA) is seen as a model for corporate governance of financial institutions around the world.

ch13 ppt rankin

Economy & Finance