introduction

PREDICTING AND PREVENTING

CORPORATE FAILURE.
CORPORATE FAILURE
 Enron ,Century bank, Intermarket, ENG are
examples of perfect companies which were going
great but whose greed and intentional
malpractices finally caught up with them and led
to their downfall.
 Basing on Enron saga, there are ways in which
we can predict and prevent corporate failure.
WHAT IS CORPORATE FAILURE
 It is a condition or fact of not achieving the desired
end or ends.
 Failure may manifest in different ways but the
main indicator being the inability of an
organization to survive.
 These could be inability to :
 achieve satisfactory return on capital in the
long term.
 Settle debts as they fall due.
 Convert assets into cash
 Adapt to changing environment
 Cope with fierce competition

 Raise funds or utilise them efficiently

REASONS FOR CORPORATE FAILURE

 Argenti (1976) in corporate failure model

classified the causes into internal causes and

external causes:
INTERNAL
 These are:
 inefficient or fraudulent management
 a high level of debts,
 defective credit policies
 lack of internal controls
 inability to cope with change
 failure to measure the performance of an
organization effectively.
EXTERNAL FACTORS
 Caused by external factors such as rigid Gvt
regulations for example Telecel Zimbabwe, pressing
demands, pressing demands of labour unions and
natural disasters.
 According to Agenti, the four main causes failure are:
 Leadership traps
 Monolithic cultures
 Power and politics
 Structural memories.
OTHER COMMON REASONS FOR FAILURE ARE:

 Cash flow problems

 Poor business planning
 Fall in demand for the product
 Rise in cost of lack of control of cost
 Organizational life cycles
 Inability to adapt to the changing environment.
ASSESSING POTENTIAL LIKELIHOOD OF CORPORATE FAILURE

 Several researches have been carried out on

corporate failure with numerous failure
prediction models developed.
 Indicators of corporate failure can be present ten
years prior to the actual failure.
 However, models should be efficient to assess
such indicators.
QUANTITATIVE MODELS
 Financial ratios help in assessing the financial
stability of an organization.
Financial ratios
 These can be used to determine financial stability

of an organization. These can be classified as:

RATIO
a) Performance Ratios – shows Gross margin, operating margin , return
performance of an organization. on capital employed.
b) Efficiency ratios - indicate the efficiency Labour turnover ratios and labour efficiency
levels at which the organization is ratios.
functioning.
c) risk- related ratios- indicate the obligation Gearing ratios – debt source coverage ratios
fulfilling capacity of a borrowing and Bover’s failure ratio.
organization.
d) Liquidity ratios- indicate capability to Current ratios and cash exhaustion ratio,
meet short term obligations. debtor days, creditor days and stock days.
e) Market share ratios -help equity Price earning ratio, earnings per share and
shareholders to value their investments and dividend yield ratio.
assess their returns from them.
 These ratios can be used to assess the
performance of an organization- although a
single ratio cannot be fully relied on to predict
corporate failure.
 The use of model is highly recommended and
the common models are:
BEAVER’S UNIVARIATE MODEL
 This was developed by William Beaver in
1967 and tried to distinguish failed
organisations from non- failed orgs by use of a
single financial ratio.
 It is based on the belief that orgs that were
about to experience financial distress exhibited
features different from those that were not
going to experience financial distress and a
single ratio is able to identify the orgs in
danger of failure.
 Beaver found a number of indicators that could
discriminate between matched samples of failed
and non- failed firms as long as five years prior to
failure.
 In his study, he used 30 financial ratios to
compare 79 manufacturing firms that had failed
with 79 others that had remained solvent.
 He pointed out inability to repay debts as a good
indicator of potential corporate failure and hence
operating cash flows provide a better measure of a
business’s profits than earning as the co can show
positive earnings but still failing to pay debts.
 Thus Beaver’s failure ratio = operating cash flow/ short term
and long term debts
 Companies with Beaver’s failure ratio of less than 0,3 fail
within five years.
 Example
 All the sales and purchases are in cash for Mugo ltd.
 Profit before taxation after depreciation –3000
 Depreciation 9000
 Decrease in inventories 8000
 Long term loans from banks 150 000
 Debentures 30 000
 Loans repayable within 12months 12 000

 Determine stability of Mugo ltd.

 Beaver’s failure ratio =operating cash flows
short term + long term
debt
= 30 000+ 9 000+ 8000
12000 + 30 000 + 15
000
= 0,35
 Since 0,35greater than 3 Mugo ltd is out of

danger . However, the ratio is slightly more

than 0,3 and as such the company should make
efforts to improve its performance.
 NB operating cash flows = operating profit plus depreciation
plus changes in working capital.
 Advantages
 Univeriate model very simple to use
 Requires no statistical knowledge and each ratio is compared
with the cut off/ standard and failure determined accordingly.
 Disadvantages
 Believes in a linear relationship between a measure and
functional form.
 Use of a single – one ratio is tested each and the other ratio
can give different results
 Difficult to determine importance to be given to each of the
ratio.
ATERMAN’S MULTIVARIATE MODEL (Z-
SCORE) 1968
 Developed by Altman in 1968 to counter
weaknesses of single ratio. He used twenty- two
popular financial ratios and classified them into
five categories namely:
 Liquidity
 Activity/ efficiency
 Profitability
 Leverage
 solvency
 Various contributions of ratios were used to
determine the model after considering those
that were significant indicators of financial
health of a company.
 Each ratio is given a separate weight and the
values added together to obtain a score- Z-
score.
 The Z- score model is stated as;
 Z= 1,2x1+ 1.4x2 +3,3x3 +0,6x4 +1.0x5 where
Z is the overall score index and xi-5 are as
follows:
 Xi – working capital/total assets(liquidity)
 X2- retained earnings /total assets
(profitability)
 X3-earnings before interest and taxes/total
assets(productivity / activity)
 X4 –Market value of equity (including
preference shares)/ book value of total
debt(gearing)
 X5- sales /total assets (solvency)
ASSESSMENT OF Z- SCORE
Z-score Prediction

Less than 1,81 High probability of corporate failure

1,81 to 3 Needs further investigation

Above 3 Financially sound company

Thus the lower the score the higher the risk of bankruptcy.
EXAMPLE
 Determine stability of Mebo ltd for the year 2019
with the help of a Z-score. The market value of
one equity share is $10.00
Income statement $000
Net sales 960
Less cost of sales 568
Trading profit 452
Less operating expenses 393
EBIT 59
Less interest payable 15% 22
37
Less tax payable @25% 9.25
Earnings after tax 27.75
tatement of financial position of Mebo ltd for year 2019
Non current assets $000
Tangible assets 152
Intangible assets 45 197
Current assets
Inventory 91
Trade receivables 25
Cash and cash equivalents 78 195
Total assets 392
Equity and liabilities
Share capital(10 000@$9.00) 90 ) 90
Retained earnings (reserves) 97 187
Long term loans 150
Current liabilities
Trade creditors 55
Total equity and liabilities 392
ANSWER
 X1=Working capital/total assets = 0,36
 X2=Retained earnings/total assets= 0,25
 X3= EBIT/Total assets = 0.15
 X4= Market value of equity/bk value of debt
= 0,49
 X5 =sales / total assets = 2.44
 Z- score = 1,2x1+1,4x2+3,3x3+ 0,6x4 +1,0x5
 =
1,2(0.36)+1,4(0,25)+3,3(0,15)+0,6(0,49)
+1,0(2,45)
 = 4,021

 As Z-score is above 3 it can be concluded

that Mebo ltd is financially sound.