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Introduction
Financial failure is the rule rather than the exception in entrepreneurial ventures. Its occurrence is alarming even in well-established businesses. Many reasons exist for financial failure. Sometimes these factors are beyond the control of management, but most of the times they could have been foreseen and prevented.
For over a decade, we have advised and assisted companies in growing and managing their businesses. This case study highlights the importance of proper financial planning and management of various financial issues. This real life example shows how many factors end up in financial disaster.
Why this company failed?
It is usually a number of factors that lead to the financial downfall of a company. Analyzing a company’s failure a narrative presents itself as a thread that runs through the various mistakes. We analyzed data on behalf of the shareholders of this medium-sized company and the company’s largest supplier. By that time the company was already in financial trouble. The main reasons for this failure can be summarized as follows:
- financial acumen. Problems began within the company when managers were appointed with a lack of experience and financial acumen.
- Financial Planning. No financial planning was done – not even cash flow projections. All were measured on sale.
- Gross profit. Gross margin averaged 3.3% over the past three years. This is extremely low in an industry that operates around 20% margin.
- sales. The rationale behind the low gross margin was to achieve sales at all costs. Initially sales increased to $135 million (from $58 million) and this gave them about 35% market share (in their niche market). At that stage they were not able to serve the customers properly and the sales dropped to $91 million during the last year.
- Expense. Operating expenses rose from 2.9% to 5.7% during this time of crisis – much higher than the 3.3% gross profit. It was a recipe for financial disaster. The increase in expenses was mainly due to convention costs, salaries, entertainment and products that were just given away.
- debtor. The management decided to loosen its credit policy to aid sales. They also didn’t want to offend their customers and were very generous with the collection. The net effect was that accounts receivable went from an already bad 66.8 days to 93.4 days. Bad loans increased from 0% to 0.8%.
- inventory. Stock holding was more or less stable at 43.6 days. The industry average is about 30 days. Management bought additional stock at discounted prices. Unfortunately most of these stock items were not excellent sellers.
- loan. The debt-equity ratio changed over time from 15.4:1 to 28.9:1. Accounts payable (creditors) were paid on average 211 days – up from 147.8 days. The industry norm is 90 days. Interest costs worsened the problems and increased from $644,000 to $1.81 million during the last two years.
The cumulative effect of these problems was devastating. The proportions were very bad. The company was not profitable, liquid or solvent. No investor or bank was willing to invest anything in the company. Creditors took legal action and the once healthy (but small) company was liquidated and liquidated less than five years after new management took over.
How can all this be stopped?
The company’s problems really began when they reorganized and appointed shareholders to key management positions. These people did not have the necessary business- and financial acumen. They were also given an independent regime and this raised attitude-, ethical- and corporate governance concerns. By the time the situation was investigated, it was too late.
Apart from hiring the right qualified people (with very low wage bill at market related remuneration), a few changes could have made a big difference:
- Financial Planning. Professionally managed cashflows could indicate where potential problems lie and corrective actions could be implemented. Financial planning may also have shown that too low a gross margin and way too many expenses is a guarantee of financial suicide.
- gross profit and sales. The company should have maintained its previous sales (around $58 million) while targeting gross margins in the region of 20% and keeping its service levels the same as before. This would give them a gross profit of $11.6 million (compared to around $3 million currently) – more than enough to cover expenses, provide growth, and bring their financial ratios to an acceptable level.
- Expense. Keeping salary relevant to the market, the company could easily save $1.5 million per year by reducing entertainment and convention costs and not giving away products.
In addition to the above the inventory holding (stock) and days debtors (accounts receivable) could have been significantly improved. However, accounts payable were in such bad shape that drastic changes were necessary. The impact of these changes will mean that a further $3.5 million will be required in the form of working capital. The net effect of all these changes to the company would have been surplus cash of approximately $4.6 million. This was sufficient for the company to meet its interest commitments, improve its ratios and grow the business consistently.
Summary
It is rarely an issue that causes the financial failure of a company. Sometimes obvious small changes are necessary to increase your chances of financial success in business. It is important for management to acquire the necessary financial skills, plan properly, diligently monitor financial performance (especially against cash flow) and take corrective action where necessary (preferably proactively).
Copyright © 2008 – Wim Venter
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