business failure[1]

8/22/2019 Business Failure[1]

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Objectives of the study:

At the end of the discussion, the students were

expected to:

1. Know how business failures arises in business.

2. Learn how business was reorganized.

3. Know how business liquidates.


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BUSINESS FAILURE

Defined and Classified


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Business failure refers to the following:

i. All industrial and commercialenterprises that are petitioned for

bankruptcyin the courts;

i. Concerns which are forced out of

business through such actions in the

courts asforeclosure, execution, andattachments with insufficient assets to

cover all claims;


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iii. Concerns involved in actions in courts

and other government agencies (likethe Securities and Exchange

Commission and the Central Bank)

such as receivership, reorganization,or arrangement;

iv. Voluntary discontinuance with known

loss to creditors; andv. Voluntary compromises with creditors

out of court.


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Classes of Failures


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Failures may be classified either as:

Economic Failure. This happens when

the firms revenues no longer cover costs.

Financial Failure. This happens when

the firm becomes insolvent or is unable topay its debt.


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Financial failure is a result of any of the

following:-- when the firms assets are more

than its liabilities, but with the assets

not liquid enough to settle itsmaturing obligations; or

-- when the firms assets are less than

its liabilities.


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Causes

ofFailure

External cause

Internal cause


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External Causes of Failure1. Recession is an external factor in which most business firms are

helpless in coping with. Some of the firms may even fail. A

recession is a phase in the business cycle characterized by a slowingdown of the rate of growth of business in general.

2. Change in a government regulation or contract. An example of this

is the requirement for an increase in the minimum paid-up capital

of life insurance firms. The new capital requirement of at least P10

million was reported enough to justify the folding up of some of the20 small life insurance firms.

3. Burdensome taxes or tariffsjack up the final selling price of the

commodities of the affected industries. Most often, the decline in

sales force some of them to cease operations. (This difficultybecame evident in the case of the automotive industry during the

past decade.)


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4. Court decisions are sometimes enough to force a business to cease

operations. An example is the recent ruling of the Supreme Court

upholding a 1982 order of the Securities and Exchange Commission

regarding the liquidation of Philippine Underwriters FinanceCorporation.

5. Legislation unfavorable to the specific type of business is sometimes

passed by law-making bodies. The effect is the permanent closure of

the affected businesses. This explains the strong objections raised by

some quarters in the approval of the proposed Omnibus Investment

Code if approved and implemented will seriously jeopardize their

operations.

6. Labor costis one factor taken into consideration by the management

of firms. When they become prohibitive, some firms considerpermanent closure.


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7. Labor strikes. Some strikes, however, inflict serious damage

to the firm leaving it without an option but to permanently

stop existing as a firm. (The decision of Holland Milk

Products to quit after a labor strike was averted only by theunions own conciliatory move.)

8. Dishonest employees. When assets are continuously

misappropriated, the firm affected may not be able to

withstand such activities and may finally fail as a goingconcern.

9. Disasters or acts of Godlike drought, typhoons, floods and

earthquakes sometimes inflict losses to firms which in some

cases are sufficient to cause failure.


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Internal Causes of Failure1. Overcapitalization in debt

2. Undercapitalization in equity

3. The inefficient management of income jeopardizes the earning

power of the firm. Income generated from sales, for instance, may

not be placed in the best possible option to earn money at a certainrisk level which can be afforded by the firm.

}cause difficulty in the firmsoperations. For one, rising interest payments mayseriously deplete funds. The firm may also be

unable to refinance its maturing obligations.

These difficulties caused by too much borrowing

and too little investments made by the owners

may finally force a business to fail.


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4. Inferior Merchandise may sometimes be the only culprit involved in

the difficulty of generating income for the firm. Under conditions of

competition, an inferior product may lose out in the market.

5. Improper costing does not reflect what actual costs are and ifcontinuously done may ultimately contribute to business failure.

6. Expansion of activities are done based on certain assumptions. As

investments in funds, materials, and personnel are made, any error

in judgmentcould cause serious flaws which may result to business

failure.7. Inefficient pricing decisions may force a business to fail. Products,

for instance, may be priced out of the market.

8. When a firm cannot improve its weak competitive position, its funds

are continuously drained, forcing the firm into bankruptcy.


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Symptoms of Failure

Statistical Data are

sometimes usefulin identifying

indications of

impending

business failure. Inthis regard,

financial ratios

play an important

role.


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a. Cash Flow to Total debt

Viable firms have higher cash flow to

total debt ratio. When this ratio gets lower,

the financial standing of the firm weakens,and when it gets even lower, failure

approaches.

b. Market Price

Approaching failure is also indicated by

a declining market price of the firms stock.

This is the result of the decreasing confidence

of the investors in the survival of the firm.C. Working Capital to Total Assets

When this ratio declines, failure

approaches. The decline reflects the

inadequacy of working capital.


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d. Retained Earnings to Total Assets

It provides a source of funding for

unexpected costs, delays, or credit crunches. A

decline in this ratio indicates approachingfailure.

e. Earnings Before Interest and

Taxes to Total Assets

this ratio reflects the adequacy ofcashflow in relation to the firms liabilities. A

lower ratio means a lesser chance of settling

debts.

f. Market Value of Equity to Book Value of Debt

When debts are used excessively, the

market value of the stock goes down because of

increased financial risk. This is indicated by a

lowering down of the ratio.


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g. Sales to Total AssetsA decreasing sales to total

assets ratio reflects a shrinking

market for the product. As the ratio

gets lower, the firm approaches

failure.


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Remedial Action

forBusiness Failures

consist of:

Rehabilitation

Liquidation


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REHABILITATION

- is an attempt to keep the firm going. It may beachieved through any of the following:

1) Formal proceeding called reorganizationReorganization. This term refers to a formal

proceeding under the supervision of a court. It is

usually a revision of the firm's financial structure,

including short-term liabilities as well as long-term

debt and stockholders equity, in order to correct

gradually the firms immediate inability to meet its

current payments.

R i ti l ll f


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Reorganization plans may call for:

a. Refinancing- refers to the replacement of

outstanding securities by the sale of new

securities. Refinancing may be classified as: Refunding- refers to the sale of a new bond

issue to replace an existing bond issue

Funding- retirement of a preferred stock with

the proceeds of a borrowing

Reverse Funding- issuance of common stocks

as a means of paying off outstanding bond

issues

b. Recapitalization- is undertaken when a group

of existing security holders accepts a newissue in voluntary exchange for the

issue it now holds


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2) Voluntary Agreement

When creditors and stockholders

agree to give the firm a chance to get back

on the right track under a mutuallyaccepted plan, the action referred to is

called voluntary agreement.

Voluntary Agreements may fall underany of the following:

a. Extension- payment dates are postponed on

at least a portion of the firms short-term

liabilities including maturing long-term

debt. In short, the creditors allow the

firm more time to settle its obligations.


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b. Composition- the creditors accept a partial

payment in full settlement of their claims

thereby releasing the debtor firm from its

obligations to them. The creditors agree to acomposition when they feel there is a small

chance for the firm to recover. Composition plans

have the advantage of not dragging on like the

extension. The firm starts out with a less onerous

financial structure upon settling all the claims of

major creditors.

c. Creditor Management- occurs when a committee

of the creditors take over the firm. The creditor

management, then, tries to get the businessback on its feet.


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LIQUIDATION

- according to Hermanson and others, itoccurs when a firm dissolves and ceases to exist and its

assets are sold. Liquidation may be accomplished through

any of the following:

1) A Voluntary Agreement Called AssignmentAssignment. It is an out-of-court settlement where the

creditors select a trustee to sell all assets and distribute the

proceeds.

All creditors must agree to the terms of assignment.

Only cash payments are made and the absolute priority

rule is usually followed.


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2) A Formal Proceeding called

Liquidation Under BankruptcyBankruptcy. Weston and Brigham

defines bankruptcy as a legal

procedure carried out under the

jurisdiction of special courts in which a

business firm is formally liquidated and

claims of creditors are completely

discharged.

BUSINESS CHART SUMMARY


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BUSINESS

FAILURE

Rehabilitation

Composition

Reorganization

Liquidation

Recapitalization

Assignment

Voluntary

Agreement

Bankruptcy

Extension

Refinancing

Creditor

Management

CHART SUMMARY

business failure[1]

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