Business Failure - Financial Management

The remainder of this chapter considers what happens when businesses experience severe and extended problems that might cause failure. The purpose is to present an overview of business failure and the alternatives available to the failing firm. In this section, we define business failure and discuss its frequency and causes. The following section examines the various alternatives available to failing firms including the procedures involving the federal bankruptcy laws.

Definitions of Business Failure

Business failure can be considered from both an economic and a financial viewpoint. In an economic sense, business success is associated with firms that earn an adequate return (equal to or greater than the cost of capital) on their investments. Similarly, business failure is associated with firms that earn an inadequate return on their investments. An important aspect of business failure involves the question of whether the failure is permanent or temporary. For example, suppose a company has $1 million invested in assets and only generates operating earnings of $10,000. Obviously, this 1 percent return on investment is inadequate. However, the appropriate course of action depends to some extent on whether this business failure is judged to be permanent or temporary. If it is permanent, the company should probably be liquidated. If failure is temporary, the company should probably attempt to “ride out the storm,” especially if steps can be taken to speed the company’s return to business success. From an economic standpoint, business failure is also said to exist when a firm’s revenues are not sufficient to cover the costs of doing business.

It is more common, however, for business failure to be viewed in a financial context, as a technical insolvency, a legal insolvency, or a bankruptcy. A firm is said to be technically insolvent if it is unable to meet its current obligations as they come due, even though the value of its assets exceeds the value of its liabilities.13 A firm is legally insolvent if the recorded value of its assets is less than the recorded value of its liabilities. A firm is bankrupt if it is unable to pay its debts and files a bankruptcy petition in accordance with the federal bankruptcy laws.

Business Failure Statistics

During the 1990s, approximately 79,000 businesses failed each year in the United States— a failure rate of slightly less than 1 percent of all listed businesses. About 30 percent of the businesses that failed in those years had liabilities over $100,000. Another interesting characteristic involves the ages of failed businesses. As shown in, about 30 percent of all companies that failed had been in business three years or less and about 50 percent had been in business five years or less. Only about one-quarter had been in business more than 10 years.

lists some large bankruptcy filings through 2003. A number of these companies, such as Federated Department Stores and Continental Airlines, have successfully reorganized themselves while in bankruptcy and have emerged to become profitable again. Other companies, such as ANR Rental, were liquidated and ceased to exist. For a number of companies the outcome is pending and may not be known for some time. In the case of Penn Central (the largest U.S. railroad), it took more than eight years for the company to emerge from bankruptcy.

Causes of Business Failure

Failures by Age of Business

Failures by Age of Business

shows the causes of business failure for companies that have failed. Although there are a number of reasons why businesses fail, most failures seem to be due at least in part to economic factors, financial causes, and lack of experience on the part of the owners of the businesses.

Selected-Large-Company-Bankruptcies

When businesses experience problems such as inadequate sales and heavy operating expenses, they frequently encounter cash flow problems as well. As a result of the cash flow problems, these businesses often increase their short-term borrowings. If the problems persist, the cash flow difficulties can become more acute, and the business may not be able to meet its obligations to its creditors on a timely basis.

Many of these characteristics of failing firms were measured by the financial ratios used in the Altman bankruptcy prediction model discussed in. Such financial variables as sales, operating expenses (through its effect on EBIT), short-term borrowings (debt), and cash flow (through its effect on net working capital) were all components of one or more of the ratios used to forecast failure.

Causes-of-Business-Failures


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