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.

BUSINESS FAILURE Defined and Classified

Business failure refers to the following:

i. All industrial and commercial enterprises that are petitioned for bankruptcy in the courts;

i.

Concerns which are forced out of business through such actions in the courts as foreclosure, execution, and attachments with insufficient assets to cover all claims;

iii. Concerns involved in actions in courts and other government agencies (like the Securities and Exchange Commission and the Central Bank) such as receivership, reorganization, or arrangement; iv. Voluntary discontinuance with known loss to creditors; and v. Voluntary compromises with creditors out of court.

Classes of Failures

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 to pay its debt.

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 its maturing obligations; or -- when the firms assets are less than its liabilities.

External cause

Causes of Failure

Internal cause

External Causes of Failure

1. 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 slowing down 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 the 20 small life insurance firms. 3. Burdensome taxes or tariffs jack 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 difficulty became evident in the case of the automotive industry during the past decade.)

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 Finance Corporation. 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 cost is one factor taken into consideration by the management of firms. When they become prohibitive, some firms consider permanent closure.

7.

8.

9.

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 the unions own conciliatory move.) Dishonest employees. When assets are continuously misappropriated, the firm affected may not be able to withstand such activities and may finally fail as a going concern. Disasters or acts of God like drought, typhoons, floods and earthquakes sometimes inflict losses to firms which in some cases are sufficient to cause failure.

Internal Causes of Failure

1. Overcapitalization in debt 2. Undercapitalization in equity cause difficulty in the firms operations. For one, rising interest payments may seriously 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.

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 certain risk level which can be afforded by the firm.

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 if continuously 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 judgment could 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.

Statistical Data are sometimes useful in identifying indications of impending business failure. In this regard, financial ratios play an important role.

Symptoms of Failure

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.

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 approaching failure. e. Earnings Before Interest and Taxes to Total Assets this ratio reflects the adequacy of cashflow 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.

g. Sales to Total Assets A decreasing sales to total assets ratio reflects a shrinking market for the product. As the ratio gets lower, the firm approaches failure.

Rehabilitation

Remedial Action consist of: for Business Failures

Liquidation

REHABILITATION - is an attempt to keep the firm going. It may be

achieved through any of the following: 1) Formal proceeding called reorganization Reorganization. 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.

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 new issue in voluntary exchange for the issue it now holds

2) Voluntary Agreement When creditors and stockholders agree to give the firm a chance to get back on the right track under a mutually accepted plan, the action referred to is called voluntary agreement. Voluntary Agreements may fall under any 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.

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 a composition 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 business back on its feet.

LIQUIDATION
- according to Hermanson and others, it
occurs 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 Assignment

Assignment. 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.

2) A Formal Proceeding called Liquidation Under Bankruptcy

Bankruptcy. 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 FAILURE Rehabilitation Reorganization Voluntary Agreement

CHART SUMMARY

Liquidation

Assignment
Recapitalization Refinancing

Bankruptcy

Extension

Composition

Creditor Management