Some methods that a business could use to identify (and prevent) the possibility of bankruptcy.

November 05, 2019

In any business there comes times when its existence is threatened. The risk of economic fluctuations matter mostly in the businesses during these times. The most important part of maintaining a business is preventing and overcoming these risks in the economic state.
Bankruptcy is often faced in a company usually because of the poor management decisions and financial crises. The influence of internal and external risks quite often ends with a profound crisis of the enterprise, its bankruptcy and liquidation.
The research article taken into account is about having a deeper insight about the failure of a company in Lithuania. It gives more understanding of the relationship between the characteristics of a company, the underlying causes of failure and the financial effects. (Burksaitiene & Mazintiene, 2011)

Identifying business bankruptcy
Paul Ormerod (2005) reminds us: “Failure is the most fundamental feature of both biological systems and human social and economic organizations.” Failure of company relates to a misalignment between the company and their deployment In order to reach their company’s goal (Turner, 2005).
  • When the company is shortage on resources then they cannot align with the environmental requirements and cannot sustain a strategic position in the market.

  • According to the research article Dun & Bradstreet statistics (Holland, 1998) 88, 7 % of all business failures are due to management mistakes. Therefore lack of managerial incompetency leads to lack of motivation and commitment to the company.
  • Shortage of finance is the most primary challenges for a failure of a business. Being unable to repay the loans and debts often leads to bankruptcy.
Preventing business bankruptcy
In order to achieve the company goals and prevent business bankruptcy it is necessary to:
  • Analyze existing approaches to finding ways of financial recovery.

  • Explore the causes of the crisis and the main directions of their diagnosis.

  • Review the effectiveness of the practical applications of the proposed instruments to identify the factors most influence on the activity of the business. 
Research methodology and data analysis
The findings in the article were based on a scientific literature overview and statistical research. The methodology applied is fundamentally based on grounded theory interpretation with a focus on classifying the identified relevant variables.

Table 1: Common Sense Failure Detector

The company signs
•The company announces using a new accounting company or having new banking relations;
• Surface of management dispute;
• Resignations of members of the board;
• Reduction of credit line;
• Common stock is sold in a depressed market or for the lower than book value;
• Company executives sell stocks;
• A major write-off assets take place;
• The company is seen disregarding it‘s decline in financial situation.
The product signs
• New competition enters the market;
• Competitors seems to be selling products that are generation ahead; • Research and development budget is proportionally lower than competitors;
• Retailers always seem to be overstocked;
• Friends and neighbors ask you to explain why you bought that company’s product
Source: Harlan D. Plat., 1999.

The common sense technique uses the subjective measure therefore even if all thirteen signs are visible the company may survive or even prosper. Even though these signals do not mean bankruptcy, they should be treated seriously.

Table 2: Selected financial ratios detecting failure symptoms

External financing index ratio = Cash from operations/Total external Financing sources (debt)
This ratio shows a company's ability to provide sufficient cash from its operations to meet its obligations to external creditors when they mature. This ratio is important to view the liquidity of a company from an external conservative point of view.
Cash sources component percentages ratio = Cash from financing/Total sources of cash
This ratio relates the cash from financing activities to total cash sources during the period. This ratio also indicates how much the company relies on debt and investment by owners rather than cash generated internally from operating activities or from investing activities.
Financing policies ratio = Cash from financing activities/Total Assets
This ratio shows the percentage of assets that were funded by creditors and owners during the period. A high ratio may indicate that the company is not using its resources (assets) effectively or to best advantage. A high ratio also may indicate that the company faces a problem due to additional cash burden in the future as the interests and loans repayments become due.
Operating cash index ratio = Cash from operations/Net income
This ratio assists current or potential investors and creditors in evaluating the "quality" of a company's earnings. Generally, the higher this ratio, the better the quality of earnings. This ratio also indicates a company's ability to produce cash internally from its ongoing operations.
Operating cash inflow ratio = Cash from operations/Total sources of cash
This ratio indicates what proportion of cash inflows is generated internally from operating activities. A high ratio generally indicates a strong financial position for the company.
Operating cash outflow ratio = Cash used in operations/Total sources of cash
This ratio indicates what proportion of total cash generated from all sources is used in operations. The lower the ratio, the higher the profitability and the greater the probability of success of the company.
Long-term debt payment ratio = Cash applied to long-term debt/Cash supplied by long-term debt
This ratio compares a company's cash disbursements to pay long-term liabilities with cash receipts from long-term liabilities. Generally, the higher the ratio, the stronger the company's ability to settle its long-term liabilities as they become due.
Productivity of assets ratio = Cash from operations/Total assets
This ratio shows the percentage of cash generated from operating activities on each dollar of asset invested and measures the productivity of assets. The higher the ratio, the greater the efficiency of the use of assets and the better the company's financial position.
Source: Using cash flow ratios to predict business failures. Journal of Managerial Issues, 1995.

The financial ratios are easy to calculate using company‘s financial statements. The researchers used procedures for selecting the eight financial ratios from the cash flow statement as they are most useful in discriminating between bankrupt and non-bankrupt companies.

Bankruptcy management practice in Lithuania shows that for many of companies hit by the bankruptcy process is very painful and the initial diagnosis of the signs of the bankruptcy process is extremely important. The main cause of bankruptcy is a crisis in the company. Conducting crisis management policies will enable the company to respond quickly to negative effects of internal and external environment. From a scientific point of view, this model is a first step towards a consensus on how and why companies fail which offers a solid theoretical basis for a future research about failure prevention.

Turner, I. (2005). Corporate failure . Henely Manager Update, 1-10.

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