Financial failure is more the rule than the exception in entrepreneurial projects. Even in established companies, the occurrence of this is alarming. There are a variety of reasons for financial failure. Sometimes these factors are beyond management’s reach, but most of the time they could have been foreseen and prevented.
For more than a decade we have advised and supported companies in growing and running their businesses. This case study underscores the importance of proper financial planning and dealing with the various financial issues. It shows a real-life example of how many factors led to financial disaster.
Why did this company fail?
There are usually several factors that cause a company to go down financially. By analyzing the failure of a company, a storyline emerges with a common thread that runs through the various mistakes. On behalf of the shareholders and the company’s largest supplier, we analyzed the figures of the medium-sized company. At this point, the company was already in financial ruin. The main causes of this error can be summarized as follows:
- Financial Acumen. The company’s problems began when managers with a lack of experience and a lack of financial understanding were hired.
- financial planning. No financial planning was done – not even cash flow projections. Each was measured by sales.
- gross profit. Gross margins have averaged 3.3% over the past three years. This is extremely low in an industry that operates at around 20% margins.
- Sale. The reason for the low gross margins was to make sales — at any cost. In the beginning, sales grew to $135 million (up from $58 million), which gave them a market share of about 35% (in their niche market). At that level, they couldn’t afford to serve customers properly, and last year sales fell to $91 million.
- Expenditure. During this period of crisis, operating expenses rose from 2.9% to 5.7% – well above gross profit of 3.3%. This was a recipe for financial disaster. Increases in expenses are primarily due to conference costs, salaries, hospitality and just gift giving.
- Debtor. Management decided to ease its credit policy to support the sale. They also didn’t want to offend their customers and were very lenient with collections. The net effect was that accounts receivable fell to 93.4 days from an already poor 66.8 days. Bad debts increased from 0% to 0.8%.
- Inventory. Storage was more or less constant at 43.6 days. The industry average is around 30 days. Management purchased additional shares at discounted prices. Unfortunately, most of these stock items were not excellent sellers.
- Debts. The gearing ratio changed over time from 15.4:1 to 28.9:1. Payables (creditors) were paid on average in 211 days – versus 147.8 days. The industry norm is 90 days. Interest costs are compounding the problems, rising from $644,000 to $1.81 million over the past two years.
The cumulative impact of these problems has been devastating. The ratings were extremely bad. The company was not profitable, liquid or solvent. No investor or bank was willing to put anything into the company. Creditors sued and a once healthy (but smaller) business was wrecked and liquidated within less than five years of being taken over by new management.
How could all this be prevented?
The company’s problems only began with the reorganization and the appointment of shareholders to key management positions. These people didn’t have the necessary business and financial acumen. They were also given free rein, which raised hiring, ethical and corporate governance concerns. By the time the situation was investigated, it was already too late.
Aside from hiring the right qualified people (at a much lower payroll on market-rate compensation), a few changes could have made a big difference:
- financial planning. Professionally managed cash flows could have provided clues as to where potential problems lay and corrective action could have been taken. The financial planning would also have shown that the path of gross margins that are too low and overspending is guaranteed financial suicide.
- gross profit and sales. By targeting gross margins in the 20% range and maintaining the level of service as before, the company should have maintained its prior revenue (around $58 million). That would give them gross profits of $11.6 million (compared to about $3 million currently) — more than enough to cover expenses, fuel growth, and bring their financial metrics to acceptable levels .
- Expenditure. By keeping salaries in line with the market, cutting entertainment and conferencing costs, and not giving away products, the company could easily have saved an additional $1.5 million a year.
In addition, inventory management (warehouse) and accounts receivable days (debtors) could have been significantly improved. However, accounts payable was in such a bad state that drastic changes were necessary. The impact of these changes would mean requiring an additional $3.5 million in working capital. The net effect of all these changes to the company would have been approximately $4.6 million in cash surplus. This was enough to service the company’s interest obligations, improve the key figures and steadily expand the business.
It is seldom just one problem that leads to the financial failure of a company. Sometimes seemingly small changes are needed to increase a company’s chances of financial success. It is important for management to acquire the necessary financial acumen, to plan properly, to carefully monitor financial performance (particularly through cash flows) and to take corrective action when necessary (preferably proactive).
Copyright © 2008 – Wim Venter