Why businesses fail

Why businesses fail

In my previous discussions on measuring performance of businesses, I indicated that both financial and non-financial indicators can reveal a lot about whether the business will survive into the future or not. The financial (lagging) indicators show how the business has performed in the past year/s whereas the non-financial (leading) indicators show how the company is likely to perform into the future.

From these indicators, you can assess the chances of the company surviving into the foreseeable future. In this article I will discuss those issues that business leaders should attend to if they have to reduce chances of their businesses collapsing. I hope business leaders will learn from these reasons for failure and therefore avoid repeating them.
In recent years, the business environment has been marred by a series of major corporate failures and catastrophic collapses, in the likes of Enron, Kodak, AIG and a lot more. With each of these corporate failures there are certain symptomatic issues they all had in common which led them to fail.

One of the most obvious reasons for corporate failure is managerial inefficiency and ineffectiveness. This could result from a lack of a well-articulated corporate strategic plan which is executed and regularly monitored by top management. The other factors which would be related to managerial inefficiency and ineffectiveness could be over expansion, ineffective sales force, high production costs, inappropriate costing strategies, low productivity, poor financial management strategy, poor risk assessment strategy and lack of staff development among others.
Another issue that causes corporate failure is the lack of an effective board. Lack of critical skills, or lack of experience by board members in core business areas and the inability of non-executive directors to hold executives to account for their decisions have resulted in the collapse of businesses.

For instance, the collapse of Enron in 2001 was a result of directors that were inexperienced and a board which was riddled with conflicts of interest. The board failed on its fiduciary duties by knowingly allowing Enron executives to engage in high-risk accounting, interest transactions and extensive undisclosed off balance sheet activities. In their ruling the US lawmakers ruled that it was Enron’s ineffective board that was responsible for running America’s seventh-largest public company to the ground.

If boards have to be effective they need to be open and honest with each other and they should scrutinise the information provided by management and should be able to ask hard questions to the CEO. Usually boards that are filled with friends and people who see eye to eye on everything will not be effective because they can’t challenge the CEO or ask hard questions to the management team.

The other issue that causes the board to fail in executing its responsibilities effectively is what is regarded as risk blindness. This is a situation where boards fail to deal with identified risks but instead ignore it thereby letting the risk to grow and fester making the whole situation worse and difficult to address. Risk blindness was one of the reasons that led to the collapse and subsequent bailout in 2008 of the blue chip company AIG.

AIG had set a very ambitious strategy to increase profits by 15 percent per annum in a very challenging competitive industry. The board was blind to risky decisions that one of its executive was taking to ensure profit targets were maintained. The company ended up falsifying accounts and using false reinsurance policies to inflate its profits. The company had to be bailed out by the government because of the huge losses it had accumulated. AIG had grown rapidly from 2001 to 2007 into a $1 trillion business but in 2008 because of the board’s ineffectiveness it collapsed like a deck of cards.

The above issue with AIG is a result of the business putting high demands on achieving high profits which resulted in staff taking highly questionable and risk-taking decisions. In this instance, the board was emphasising short term profitability at the expense of long term shareholder wealth creation. The board should have dealt with this culture of risk taking instead of casting a blind eye.
This same culture of risk taking resulted in Société Générale collapsing in 2008 when its junior French trader Jérôme Kerviel was taking dangerous bets against the market. He made big gains which benefited the business for a while so the board turned a blind eye because the trader was generating so much profit.

However, when he began to make losses he ended up hiding the positions by filing a lot of tiny, fake hedge trades elsewhere. It all transpired that Société Générale’s poor company culture of wanting huge profits was to blame for the trader’s rogue trades. However the board failed to stop the rot. One other cause of corporate failure is not responding timely to technological disruption. Technological innovation has been posing huge challenges for market incumbents. Business leaders who fail to leverage new technological developments to remain competitive have sadly seen their entire huge organisations crumble to their demise because of complacency.

A classic case is the 2012 bankruptcy of iconic brand Kodak. Kodak was founded in the 1880s, and had held a monopoly over the global photography industry for almost a century. Unfortunately when the sector went digital in the 1980s, Kodak refused to acknowledge the disruptive technology only to adopt it very late when the market had shifted to the new technology.
The company’s sales dwindled as a result of smartphones which had entered the photography market. The company had to close shop in 2012.

The board should constantly be alert to what is called information glass ceiling in which internal audit teams or those responsible for risk management fail to report on risks that are coming from top management. Because of this, executives tend to overrule any red flags generated through audit processes, or information is heavily filtered by the time it reaches board-level resulting in the board making wrong decisions. This was the case at Société Générale where managers did not report or act upon internal compliance red flags raised during Jérôme Kerviel’s wild trades which clearly demonstrate how an “information glass ceiling” can lead to corporate failure.

Highly undercapitalised businesses are likely to fail. During periods of financial distress boards struggle to source liquidity and maintain high enough levels of working capital to continue operations. Undercapitalised firms can’t buy relevant fixed assets or invest money in generating assets, leading to underutilisation of capacity and ultimately failure. Undercapitalisation is one of the several core reasons why business collapse.

One other issue that can cause companies to fail is an economic downturn. Environmental economic instability can decimate sales and adversely affect the activities and performance of organisations, resulting in failure or even collapse. Some economic distress can be very difficult for the boards or executive to deal with successfully. It’s therefore very important for the board and its executive to constantly assess the impact developments in the economic environment so that appropriate strategies can be put in place to avert corporate collapse.

l Stewart Jakarasi is a business and financial strategist and a lecturer in business strategy, advanced performance management and entrepreneurship. For assistance in implementing some of the concepts discussed in these articles please contact him on the following contacts: sjakarasi@gmail.com, call on +266 58881062 or WhatsApp +266 62110062.

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