Various aspects of business failure

1. VARIOUS ASPECTS OF BUSINESS FAILURE
Business failure occurs due to different reasons. While few firms fail within first
year or two of life, few others grow, mature and fail much later. The business failure
can occur in a number of ways and also from different reasons.
Why Business Firms Fail
Let us try understand the different
reasons why corporate often fail;
 An imbalance of skills within the top echelon.
 A chief executive who dominates a firms operations without regard for the inputs
of peers.
 An inactive board of directors. The board of Directors lack of interest in the
financial position of the company may lead to insolvency.
 A deficient finance function within the firm’s management.
 The absence of responsibility for the chief executive officer.
Apart from the above mistakes the firm usually is vulnerable to several
mistakes;
 Management may be negligent in developing effective accounting system.

2.  The company may be unresponsive to change.
 Management may be inclined to undertake an investment project that is
disproportionately large relative to firm size. If the project fails the probability of
insolvency is greatly increased.
 Finally the management may rely heavily on debt financing that even a minor
problem can place the firm in a dangerous position.
The Physiology of Business Failure
In an economic sense business failure is associated with success in business
relates to firms that earn adequate return on their investment. Similarly business
failure is associated with forms that cannot earn adequate returns on their
investments. What is important is whether a business failure is permanent or
temporary. In fact the appropriate course of action depends on whether the business
failure is permanent or temporary. Thus if the failure is temporary the firm may have to
be liquidated and if the failure is permanent the firm may have to take steps to the
speed the company’s return to business.
Types of Business Failure
 Insolvency: A firm may fail if its returns are negative or even low. A firm that
consistently reports losses at operational level would experience decline in market
share and eventual closure.
 Technical insolvency: A firm is said to be facing technical insolvency when it is
unable to pay its liabilities as they become due. Thus when a firm faces technical
insolvency its assets are still greater than the liabilities but the firm is confronted
with liquidity crisis.
 Bankruptcy: When a firm has technical insolvency some of its assets could be
converted to cash to escape complete failure. If this is not done at right time, the
firm may have to face a more serious type of failure – Bankruptcy. It occurs when
firm’s assets are less than the liabilities. A bankrupt firm has a negative
shareholder’s equity. Although bankruptcy is a more obvious form of business
failure courts treat technical insolvency and bankruptcy in the same way.

3. The Challenge
When a firm faces severe problems, either the problems must be resolved or
the firm must be liquidated. At such point an important question has to be answered –
“is the firm worth more dead or alive.” The decision to continue operating has to be
based upon – The feasibility and fairness of reorganizing the firms as opposed to the
benefits of liquidating the business. When technical insolvency occurs management
must either modify the operating financial conditions or terminate the firm’s life If a
decision is made to alter the company in the hopes of revitalizing its operations, Either
voluntary agreements with the investors, or A formal court arranged reorganization
must be used. If on the other hand the difficulties are believed to be insurmountable,
then liquidation will take place either by assignments of assets to an independent
party for liquidation or by formal bankruptcy proceedings.
Voluntary Remedies to Insolvency
Once a firm begins to encounter these difficulties the firm’s owners and
management have to consider the alternatives available to failing business. Such a
firm has two remedies,
 Attempt to resolve its difficulties with its creditors on voluntary or informal
process.
 Petition the courts for assistance and formally declare bankruptcy.
The company creditors also may petition to courts and get the company
involuntarily declared bankrupt.
To Reorganize or Liquidate

4. Regardless of whether a business chooses informal or formal methods to deal
with its difficulties eventually the decision has to be made whether to reorganize or
liquidate the business. Before this decision can be made both the business liquidation
value and its going concern value has to determine.
 Liquidation value: equals the proceeds that would be received from the sale of
the business less its liabilities.
 Going concern value: equals the capitalized value of the company’s operating
earnings less its liabilities.
Normally,
If the going-concern value exceeds the liquidation value the company needs to
be reorganized otherwise it should be liquidated.
However in practice the determination of the going concern and liquidation
values is not easy due to following reasons,
 Uncertainty as to estimating the price the company’s assets will bring at auction.
 The company’s future operating earnings
 Appropriate discount rate at which to capitalize the earning may be difficult to
determine.
 Management understandably is not in a position to be completely objective,
about the above values.
Informal Alternatives for Failing Business

5. Regardless of exact reasons why a business begins to experience difficulties
the result is often same cash flow problems.
The first step taken by troubled company involves stretching its payable. In
some occasions this can keep the company busy for several weeks of needed time
before creditors take action. If the difficulties are more than just minor and temporary
the company may turn to its bankers with request for additional working capital loans.
Another possible action is the company bankers and creditors take up to
restructure the company’s debt. Restructuring of debt by bankers can be quite
complex. However debt restructuring basically involves either
 Extension,
 Composition, or
 A combination of both above.
In Extension, the failing company tries to reach an agreement with its creditors
that will permit it to lengthen the time for meeting its obligations.
In composition, the firm’s creditors accept some percentage amount lees than
their original claim and the company is permitted to discharge its debt obligations by
paying less than the full amounts and are protected from any further actions on part of
creditors while it attempts to work out a plan of re-organization.
What to Do with the Failing Firm
Another important aspect of the bankruptcy procedures involves what to do
with the failing firm. Just as in case of informal alternatives a decision has to be made
about whether a firm’s value as a going concern is greater than its liquidation value.

6. Generally if this is so a suitable plan of reorganization can be formulated and the firm
is reorganized otherwise it is liquidated.
Reorganization
If a voluntary remedy such as an extension or composition is not workable a
company can declare or be forced by its creditors into bankruptcy. As a part of this
process a firm is either reorganized or dissolved. Reorganization is similar to an
extension or composition, the objective being to revitalize the firm by changing its
capital structure – like, reduction of fixed charges by substituting equity and limited
income securities in place of fixed income securities, etc.
Corporate restructuring can occur in myriad ways. Mergers, takeovers,
divestitures, spin-offs, and so on referred to collectively as corporate restructuring
have become a major force in the financial and economic environment all over the
world.