This article is written by Pranav Sethi from SVKM NMIMS School of Law, Navi Mumbai. This article is an exhaustive analysis of corporate financial distress and failure.
Table of Contents
Introduction
Every business or position has no more than 5 or 7 critical success factors that determine how well it does. Identify the critical things you do that determine your success or failure. Make a plan to get better at each one of them.
– Brian Tracy
In today’s corporate world, where market discipline ensures the survival of the fittest, business failure is prevalent because companies fail to upgrade themselves in response to changing circumstances, causing them to cease operations. The fundamental issue isn’t the frequency of corporate failures, but rather the capacity to predict coming failures using some easily identifiable characteristics. A recurring trend of modifications in these characteristics can aid in the formulation and implementation of preventative strategies to avert such failures. This initiative could help to lower the costs of bankruptcy, avert financial hardship for all stakeholders, and contribute to the stability of the business and financial climate. Due to changes in commercial framework, provision, and application of the law, accounting, and corporate governance norms in different economic contexts such as developing markets, these suggestions cannot be applicable to firm failures in different economic situations such as emerging economies.
Corporate bodies are supposed to come up with a business strategy that matches customer demands to make money, yet many fail before they get off the ground owing to poorly written strategies, managerial inefficiency, and ineffectiveness. A corporation’s failure can also be attributed to its inability to handle the financial resources at its disposal. This might result in a liquidity problem that can be largely attributed to various parts of a company’s activities. A circumstance in which a corporation suffers significant losses and is unable to pay its stakeholders at the end of its working period, all due to managers’ incapacity to mobilize resources and make resource allocation decisions.
There is no chance for expansion, an organization that constantly incurs poor or negative returns is certain to fail sooner or later. When a company’s assets are insufficient to cover its liabilities, it is technically insolvent. A bankrupt company’s total assets will always be fewer than its entire liabilities, resulting in an asset-to-liability ratio of less than one. Technical insolvency and bankruptcy, on the other hand, are always dealt with in the same way in the courts of law.
Defining financial distress
Financial distress is a terminology used frequently in corporate finance to describe any circumstance in which a person’s or a company’s financial state causes them to struggle to pay their bills, particularly creditor loan obligations. Financial suffering that lasts for a long time can lead to bankruptcy.
When a situation of financial trouble arises, it must be handled as soon as possible to avoid the situation worsening. If financial problems are not addressed quickly, they often escalate to greater financial problems. A person or business in financial hardship, for example, may see their credit score decline. Lenders would demand them higher interest rates as a result, making it more challenging for them to borrow money to assist them to get through a period of lower income or revenue.
Financial distress in companies
Even a well to do corporation might go through a time of financial turmoil. Because commercial difficulties can arise for a variety of circumstances some of which are wholly outside the purview of a corporation. A rapid, unanticipated slowdown in the economy overall, for example, could lead to a significant decline in a company’s revenues. Many physical stores that had formerly had a strong, consistent income unexpectedly saw their earnings drop to zero as a consequence of the quarantine and lockdown implemented in the aftermath of the COVID-19 epidemic.
The dramatic rise in interest rates
A business may have taken out a substantial loan with an adjustable rate of interest. In that case, a considerable rise in interest charges can dramatically raise the cost of repaying the loan, generating financial difficulties for the business.
Of fact, a company’s financial difficulty is frequently caused by managerial failings. Financially, top executives may overextend the organization by drawing the money to fund expansion. If the borrowed funds do not result in improved revenues or profits promptly, the company may find it difficult to repay its debt obligations.
Poor marketing technique
A company’s financial difficulty can also be caused by poor marketing or price decisions. Some significant sources of financial difficulty include an extravagant advertising strategy that fails or inefficient modifications to a product or pricing system that result in a drop in sales. Even the most profitable businesses may make mistakes like this.
Considering the launch of a new beverage product, “New Coke“, by the Coca-Cola Firm in 1995, which was a disaster for the blue-chip company. Consumers overwhelmingly opposed the new beverage, resulting in a significant reduction in income and the refusal of several bottlers to distribute “New Coke”. However, it’s worth noting that when Coca-Cola discontinued New Coke and reintroduced “Coca-Cola Classic,” sales skyrocketed.
Other contributing factors of a financial strain include insufficient accounting, failure to recover accounts receivables on time (which can generate severe cash flow problems), and bad financial processes. Cutting costs, enhancing cash flow or revenues, and debt restructuring to reduce the size of debt payments are the most typical remedies used by businesses to reduce financial difficulties.
Personal financial struggle
Since many individuals struggle to make ends meet and have little or no savings, it is very easy for someone to get into financial trouble. An individual’s financial difficulty, like that of a company, maybe the result of their weak monetary planning or it may be through no fault of their own. The following are some of the most common reasons for personal financial distress:
Unexpected expenses
Unexpected large expenses, such as significant medical costs or a costly automobile repair, are another regular source of financial hardship.
Inability to properly handle finances
Even those with substantial incomes can find themselves in financial trouble if they do not handle their money properly. Expenses, such as credit card payments, can quickly add up, and a person may find themself in financial difficulty. It’s critical to keep a close eye on your finances at all times.
If you find yourself in a financial bind, your best choices are similar to those employed by large businesses: find ways to cut costs and/or raise income, and explore negotiating with lenders for at least a partial reduction in debt payment obligations.
Income loss or reduction
An unexpected loss in income can happen to anyone at any time. You may get terminated or thrown off suddenly from a job, or the organization where you operate might go out of operation, making you jobless. A serious economic crisis or other condition may force you to accept a significant wage decrease to keep your job. Whatever the reason, if you don’t have any money, you may suddenly find yourself unable to pay even your most basic bills, such as rent, utilities, and food.
Signs of financial distress
There are several indicators that a business is undergoing or will experience financial trouble shortly. Profitability issues may indicate a company’s financial health. Struggling to maintain even indicates a company that is unable to maintain itself from internal resources and needs to seek financial support. This raises the company’s operations risks and reduces its creditworthiness in the eyes of lenders, suppliers, investors, and banks. A corporation (or an individual) that restricts access to funds is more likely to collapse.
Revenue declining, poor quality service and cash flow
Revenue that is declining or growing slowly suggests that demand for a company’s products or services is not meeting expectations based on its current business strategy. Consumers may no longer be impressed with the firm’s offerings if extravagant promotional activities result in little growth, and the company may be forced to close down. Similarly, if a firm provides poor quality items or services, customers will begin to shop elsewhere, eventually causing the company to close its doors. Cash flow can be significantly strained if debtors take too long to pay their debts to the company. The company or individual may be unable to pay its debts. When a business just has one or two key customers, the danger is magnified.
Role of MSMEs
In recent years, India has seen numerous setbacks. Many market sectors have helped to protect the country’s economy in various ways. The Micro, Small, and Medium Enterprises Development Act of 2006 was used by the Indian government to launch the Micro, Small, and Medium Enterprises. MSMEs have played an important role in various areas of the Indian economy since then. It has evolved into a marketplace for beginners to continue businesses, manufacture, and sell things on a small scale and at a reduced cost.
MSMEs have contributed to social welfare in addition to commercial enterprise and have grown in importance throughout time. MSMEs’ contributions to the country’s socioeconomic and economic growth require a specific set of rules and laws. But there have been numerous changes in the industry in recent years, and they have also been regulated, appropriate management is the necessity of the hour. However, thorough inspections and the establishment of rules are required to make MSMEs more successful and beneficial.
MSME – functioning statistics
In the 2017-18 fiscal year, MSME provided 33.4 percent of overall manufacturing output, including 49 percent of total exports. As a result, MSME has a significant impact on the country’s GDP. The number of MSMEs is steadily expanding, and by 2020, many would have registered with India’s Unique Identification Authority (UIDAI). This shows that the MSME sector has been growing steadily. It has evolved into a rapidly expanding sector of the Indian economy. MSME has come a long way from being a small sector to becoming a key source of GDP in a country, and it now requires good governance.
Challenges and plans during COVID-19
In recent years, the MSMEs sector has experienced positive growth. COVID-19, on the other hand, has created a crisis situation for the corporate sector, particularly for MSMEs, which already have limited resources. The government’s Atma Nirbhar Bharat initiative, which was implemented this year, has proven to be a glimmer of hope for MSMEs. Various programs have been put in place to keep MSMEs afloat and prevent them from collapsing. The plans include providing collateral-free loans, a 12-month moratorium term, a 48-month repayment period, consideration of servicing and manufacturing MSMEs as one, and so on. These are only a few of the new MSMEs schemes.
It was critical to implement such programs to save one of India’s most vital sources of income. These plans will help people cope with the hardships that come with a pandemic. Such circumstances have put a strain on the entire industry, forcing many people to come down with their ideas and many others to suffer unwelcome and unexpected losses. The implementation of such programs will be a lifesaver for the MSME sector.
Corporate failure – causes and effects
Corporate failure can be caused by a variety of factors that can be divided into two categories: external and internal. Internal variables are those that are not directly under the control of the failing company, such as competition, the actions of the business community, changes in consumer demand, onerous regulations, and, most recently, the danger of globalization. Good management would plan and put in place all essential systems, as well as offer the required vision, initiating abilities, and perseverance to alter a company’s operations to fulfil it.
The preceding may be stated as what we term contributing factors of corporate failure, acknowledging the validity of the essential component of management but also the falseness of human judgment:
Internal factors
These are problems that are caused immediately or indirectly by mismanagement or poor corporate governance or a mix of the two, and are detailed below:
Mismanagement
Incompetent leadership, whether due to selfishness, greed, or an absence of competency, is to blame for almost all of the failures covered so far though.
Excessive costs
This resulted from the use of obsolete machinery, outmoded production methods, unproductive sales, a lack of attention to detail, and poor business organization.
Income smoothing
Management frequently engages in income smoothing actions to post larger profit figures than predicted, which would win them rewards and bonuses. In the long run, smoothing income has an impact on corporate operations and can lead to failure.
Inadequate revenue
This is caused by a lack of company sales expertise in terms of customer satisfaction, price policy, or even insufficient marketing.
Overcapitalization
This can be traced back to advertising or later financing, and maybe to rapid development. The sales of corporation stocks may have been misplayed, the business plan might have been ineffective, or subsidiary companies or even other units may have been purchased at inflated prices.
External factors
Excessive competition
A quality product in the hands of a rival poses no greater threat, shock, or fear to a corporation. As a result of competition, numerous businesses have lost market share to competitors and have had to close their doors.
Operation of the business circle
It is divided into four phases: prosperity, decline, depression, and recovery. During moments of prosperity, most businesses stockpile substantial inventories to meet the ostensibly constant wants of their clients. Many businesses are financially unable to withstand the stress when such inventory must be sold on the open market throughout times of decline or depression, and so as a consequence, many failures happen under depression than at any other period.
Public demand has shifted
A shift in public demand for a product as a result of technology developments or the emergence of new products can contribute to a company’s bankruptcy.
Casualties
This is what is known as an “act of God” or “act of nature,” and it could be a fundamental reason for problems. Earthquakes, tidal waves, flooding, crises, and other calamities can devastate a business and its practical prospects for success.
Measures to prevent commercial failure
One in every 3 new small enterprises fails during the first two years, as shown in a report conducted by the US Small Business Administration (SBA). According to the same report, more than half of those who start a business fail within the first four years (56 percent). Irrespective of the state of the economy, small business entrepreneurs can take various steps to avoid losing all of their time, money, and effort in a failing venture.
Accurate projections
Most entrepreneurs are natural optimists. They see that their beliefs have the potential to transform society, and they adopt an optimistic mindset towards their efforts. This optimism, on the other hand, may cause them to overestimate their potential income while underestimating future costs. These exaggerated expectations may lead to poor business decisions based on erroneous facts. To keep their business aspirations alive, the owners must remove their rose-coloured glasses and produce accurate income and cost estimates.
Create a solid business plan
Before starting a firm, small company owners can use the SBA’s services to prepare a business plan. As the saying goes, “If you fail to plan, you plan to fail.” While no entrepreneur sets out to establish a firm to fail, many of them begin by failing to plan. A solid business plan is a must-have for any company’s success.
Avoid high debt
For a small company, loans, credit cards, and other forms of debt can be a double-edged sword. Although most businesses rely on some form of credit to obtain the capital they require to launch, the disadvantage of credit arises when it comes time to return the loans. When a company spends the majority of its cash flow on debt repayment rather than expanding its client base or hiring new staff, it loses the ability to compete. Some businesses may want to restructure their debts. Companies that are unable to fulfil their obligations might use this process to renegotiate their debts and adjust their repayment terms to enhance their liquidity.
Cash flow management
Cash flow is a problem for a lot of new firms. These businesses must strike an equilibrium between bringing in income through sales and financing their costs. When a corporation endures prolonged durations of negative cash flow, the repercussions are similar to those of a person experiencing a decrease of blood flow: lethargy, incapacitation, and eventually death. A struggling start-up must do everything it can to generate income while keeping expenses to a minimum.
India’s corporate management failures
Here’s what some of India’s worst corporate governance failures were caused by unethical business practices.
Cafe Coffee Day
From one stage, the coffee business Cafe Coffee Day (also known as CCD) had over 1750 locations across the country. In the 2000s, it was India’s largest coffee chain. V. G. Siddhartha, the proprietor, comes from a distinguished family that has been farming coffee beans for almost 140 years. A conversation with a German coffee maker encouraged him to open Cafe Coffee Day as a Starbucks competitor just as the cafe culture was gaining traction around young people. After going public in 2015, it appeared like things were only going to get better, with reports that Coca-Cola was intending to spend a massive 2,500 crores in the company.
Nevertheless, in September 2017, the Income Tax Department launched raids at more than 20 locations associated with Siddhartha. He was said to be in a lot of debt. In the fiscal year ending March 31, 2018, his Coffee Day Enterprises Ltd’s net loss increased to Rs. 67.71 crore, up from Rs. 22.28 crore the preceding year. Considering revenue of 122.32 crores, this is the case. In 2019, he disappeared unexpectedly one evening.
He stated in a letter to the CCD Board that he was being forced by “one of the private equity partners” to buy back shares, a deal he had only partially finished six months before by borrowing a huge amount of funds from “a friend.” His body was discovered 36 hours after he disappeared in Mangalore. It appeared to be a suicide case.
Siddhartha appears to have taken on debt in his capacity to purchase land and engage in long-term projects, with unhappy lenders trying to contact him for immediate returns. While the decade of the 2000s witnessed the rise of Cafe Coffee Day, it also witnessed a growth in debt. The business required funding for both operations and capital expenditures. Around $149 million was invested in 2010 by Standard Chartered Private Equity (Mauritius) II Ltd, KKR Mauritius PE Investments II Ltd, and Arduino Holdings Ltd (who later transferred the debentures to NLS Mauritius LLC). Standard Chartered Private Equity (Mauritius) II Ltd’s compulsory conversion stock options, as well as KKR Mauritius PE Investments II Ltd and NLS Mauritius LLC’s compulsory convertible debenture, were transformed into share capital at the time of disclosure. The consolidated debt had grown to Rs. 2,700 crore by June 2015.
ICICI Bank-Videocon bribery case
After filing a criminal case for money laundering based on an FIR registered by the Central Bureau of Investigation (CBI) against the Kochhars, Videocon’s Dhoot, and others, the Enforcement Directorate detained Deepak Kochhar in September 2020. According to the federal investigation agency, Videocon Industries wired Rs. 64 crore to Nupower Renewables Pvt. Ltd. (NRPL) on September 8, 2009, out of a loan amount of Rs. 300 crore sanctioned by an ICICI Bank panel led by Chanda Kochhar (wife of Deepak Kochhar). The funds were transferred the next day after the loan was disbursed. Deepak Kochhar owns NRPL, which was previously known as Nupower Renewables Limited (NRL).
The Satyam scandal
Satyam was a publicly traded firm with a great standing and had even won the Golden Peacock Global Award for corporate governance at one time. However, the corporation conspired with auditors to deceive investors, regulators, the board of directors, and other stakeholders through false accounting methods. When the company’s Chairman Ramalinga Raju admitted to misrepresenting accounting practices, the fraud was exposed, and regulators such as the Securities and Exchange Board of India (SEBI) stepped in and began initiating measures.
Satyam’s intention to spend Rs. 7,000 crores in Maytas Properties and Maytas Infrastructure sparked the controversy. These businesses were controlled by Raju’s relatives. The investments were approved by the board on December 16, 2008, but the investors were against them. Assets such as cash and bank deposits were exaggerated, while debts were downplayed, causing the firm’s records to be falsified. As a consequence, the investors sued Satyam in a variety of ways. The Satyam board’s decision was overturned after the Maytas deal and accompanying challenges. Satyam was barred from conducting any operations for eight years by the World Bank, and four independent directors resigned.
The Satyam case generated pushback from corporate India, with many demanding immediate regulatory changes. Several organizations, including the Confederation of Indian Industries (CII), the National Association of Software and Services Companies (NASSCOM), and the SEBI Committee on Disclosure and Accounting Standards (SEBI Committee), among others, began searching into reforms to the Audit Committee, Shareholder Rights, and Whistle-blower Policy, among other things. These committees provided a variety of recommendations, which were then considered by the legislative body.
YES Bank
In March 2020, the Reserve Bank of India (RBI) gained possession of YES Bank in the absence of a realistic recovery strategy and the benefit of YES Bank’s depositors. YES, Bank’s narrative is straight out of a John Grisham novel. It began as a non-banking financial company (NBFC) in 1999 and expanded into a full-fledged bank in 2003. Former Managing Director and CEO Rana Kapoor was known for supporting up the market by consenting to distribute loans to corporate borrowers refused by other banks, and his board members were continuously fighting for the top slot. The bank would levy a hefty upfront cost, and even the majority of borrowers were willing defaulters.
YES, Bank’s monetary situation has been steadily deteriorating, owing to the bank’s failure to generate cash to handle possible loan losses and subsequent devaluations, as well as investors’ invocation of bond covenants and withdrawals of deposits. In recent years, the bank has also faced major governance concerns and procedures, which have contributed to its continuous collapse. The RBI worked closely with the bank’s management to identify methods to improve the bank’s balance sheet and liquidity. The bank’s management told the RBI that it was in discussion with several investors and that they were likely to succeed.
According to a filing on the stock exchange dated February 12, 2020, the RBI was also in talks with a few private equity firms about capital infusion options. These investors met with senior RBI officials but were unable to infuse any funds due to a variety of factors. Because a bank and market-led restoration are preferable to a regulatory restructuring, the RBI made every effort to assist such a process and provided YES Bank’s management ample time to develop a meaningful revival plan, which did not materialize. Meanwhile, the bank was experiencing continuous liquidity outflows.
Conclusion
Poor management of a corporate entity is evidenced by lack of focus, lack of transparency of obligation, operational activities, and productivity, an inappropriate approach of reporting accountants, lack of integrity in the corporate affairs internal process and system, poor self-decision making by those in charge of a concern’s affairs. The inappropriate site, too quick expansion, lack of prior institutional structure and capital allocation, incapacity to advertise big volumes of items, and poor credit collection through marketing networks are all reasons for failed business in India. It creates a vicious cycle in the business world. Poor cash flow management and the razor-thin margins offered to SMEs in competitive marketplaces reliant on distribution networks are two major causes of failure. These can be examined and observed.
References
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