Prediction and Prevention

TimDouglas,CMA,MBA Chairman IMARiyadhChapter

Causes of Corporate Failure

Corporate Collapse McRobert and Hoffman

1% Sheer bad luck 15% Internal problems triggered by external factors 52% Internally generated problems within managements control

The Trajectory of Failure

The Dangerous Dozen Corporate Collapse McRobert and Hoffman

Companiesthat:
1.

displaycertaindefectsinmanagement structure (usuallyassociatedwithoneman rule)showtwoerrorsofomissionandthreeof commission.

The Trajectory of Failure

The Dangerous Dozen Corporate Collapse McRobert and Hoffman

Thetwoerrorsofomissionare:
2. 3.

theneglectofaccountancyinformation systemsand,worse, thefailuretorespondadequatelytolongterm changesintheirenvironment.

The Trajectory of Failure

The Dangerous Dozen Corporate Collapse McRobert and Hoffman

Thethreeerrorsofcommissionare:
4. 5.

atendencytoovertrade or tolaunchabigprojectwhichisbeyondthe company'sresources,or toallowtheirgearingtoincreasesothateven normalbusinesshazardsareaconstantthreat.

6.

The Trajectory of Failure

The Dangerous Dozen Corporate Collapse McRobert and Hoffman

Theprocessofdeclineisacceleratedas 7. cashflowdeteriorates rapidly. Somecompaniesatthisstage,eventhough competentlymanaged,canbeseverely damagedby

8.

constraints thatareplacedupontheirabilityto respondtochange.

The Trajectory of Failure

The Dangerous Dozen Corporate Collapse McRobert and Hoffman

Then,asacompanyslidesdownthepathto insolvency 9. itsfinancialratiosdeteriorate,itbeginsto

10.

employcreativeaccounting.

Atthesametime, 11. certainnonfinancialsymptomsstarttoappear and

12.

thecompanybeginstoenteritsdramaticlast fewmonths.

The Five Stages of Decline

How The Mighty Fall Jim Collins

The Five Stages of Decline

How The Mighty Fall Jim Collins

HubrisBornofSuccess Markers

Successentitlement,arrogance Neglectoftheprimaryflywheel WhatreplacesWhy Declineinlearningorientation Discountingtheroleofluck

The Five Stages of Decline

How The Mighty Fall Jim Collins

UndisciplinedPursuitofMore TheMarkers Unsustainablequestforgrowth,confusingbigwithgreat Undisciplined,discontinuousleaps

The Five Stages of Decline

How The Mighty Fall Jim Collins UndisciplinedPursuitofMore TheMarkers

Decliningproportionoftherightpeopleintherightseats Easycasherodescostdiscipline Bureaucracysubvertsdiscipline Problematicsuccessionofpower Personalinterestsplacedaboveorganizationalinterests

The Five Stages of Decline

How The Mighty Fall Jim Collins

DenialofRiskandPeril TheMarkers

Amplifythepositive,discountthenegative Bigbetsandboldgoalswithoutempiricalvalidation Erosionofhealthyteamdynamics Externalizingblame Obsessivereorganizations Imperiousdetachment

The Five Stages of Decline

How The Mighty Fall Jim Collins GraspingforSalvation TheMarkers

Aseriesofsilverbullets Graspingforaleaderassaviour Panicandhaste Radicalchangeandrevolutionwithfanfare Hypeprecedesresults Initialupswingfollowedbydisappointments Confusionandcynicism Chronicrestructuringanderosionoffinancialstrength

The Five Stages of Decline

How The Mighty Fall Jim Collins

CapitulationtoIrrelevanceorDeath

The Turnaround Process

So what do we do when we sense impending doom?

Damageassessment:Factualevidenceofjusthow badlythecompanyisunderperforming? Underlyingcauses:Thesearchforclues.Howdid wegethere? Environmentalscanning:Spottingthreatsand opportunitiesthatmaycomplicateorfacilitatethe turnaroundprocess.

The Turnaround Process

So what do we do when we sense impending doom?

Takingstock:Whatresourcesdowehavetowork withandwhatcriticalresourcesaremissing? Assimilation: Theprocessofingestinganddigesting largeamountsofdataandinformation. StrategyFormulation:"Whatif?"Modeling.Target Selection.Chartingthecourse. Navigation: Milestoneaccomplishmentsand coursecorrection

The Turnaround Process

Damageassessment: Factualevidenceofjusthow badlythecompanyisunderperforming?

AltmansZScoreModel
AQuantitativeApproach
thatusesaccountingvariables

AltmansZScore
PrivateMfg.Company

TheoriginalZScore(1968),initiallydesigned forpubliclytradedcompanies,wasrevisedin 1995toaccommodateprivatemanufacturing companies.ModelAoftheZScorewasa completereestimationofthemodeltoprovide fortheimpactofsubstitutingthebookvalueof equityforthemarketvalue.

AltmansZScore
ModelA Zscoreforprivatemanufacturingfirms
Z'=0.717T1 +0.847T2 +3.107T3 +0.420T4 +0.998T5
T1 =WorkingCapital/TotalAssets T2 =RetainedEarnings/TotalAssets T3 =EBIT/TotalAssets T4 =BookValueofEquity/TotalLiabilities T5 =Sales/Total

AltmansZScore
ZonesofDiscrimination
Z'>2.9SafeZone 1.23<Z'<2.9GreyZone Z'<1.23DistressZone

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Corporate Failure - Can you see it coming?

Year Year 2011 Actual Year 2012 Actual Year 2012 What If?

Ratio Analysis

2010 Actual

Z-Factor Variables
Working Capital Total Assets Retained Earnings EBIT Shareholder's Equity Total Liabilities Sales

100,000 400,000 75,000 65,000 180,000 220,000 457,000

90,000 450,000 95,000 80,000 200,000 250,000 460,000

80,000 500,000 90,000 70,000 190,000 310,000 445,000

80,000 500,000 90,000 70,000 190,000 310,000 445,000

Altman's Z-Score ( Private Manufacturing)

Working Capital / Total Assets Retained Earnings / Total assets EBIT / Total Assets Shareholder's Equity / Total Liabilities Sales / Total Assets Altman Z-score 0.717 0.847 3.107 0.42 0.998

0.179 0.159 0.505 0.344 1.140 2.327

0.143 0.179 0.552 0.336 1.020 2.231

0.115 0.152 0.435 0.257 0.888 1.848

0.115 0.152 0.435 0.257 0.888 1.848

Underlyingcauses: Thesearchforclues. Howdidwegethere?

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ArgentisAScoreModel
Qualitativemodelsrestonthepremisethattheuseof financialmeasuresassoleindicatorsoforganizational performanceislimited.Forthisreason,qualitative modelsarebasedonnonaccountingvariables.One ofthemostnotableoftheseistheAscoremodel attributedtoJohnArgenti(1976)whichsuggeststhat thefailureprocessfollowsapredictablesequence:
Defects Mistakesmade Symptomsoffailure

Defects
Management Chief Executive is an autocrat Chief Executive also holds position of Chairman Passive Board of Directors Unbalanced Board of Directors, not representing all business functions or overweight in one discipline Weak Finance Director Poor management depth Accounting No budgets or budgetary controls No cash flow forecasts, or not up to date No costing system: costs and contribution of each product or service are not known Poor response to change: old-fashioned product or service, obsolete production facilities, out-of-date marketing methods, old directors. Defects Scoring

Max Score 8 4 2 2 2 1 3 3 3 15 43

This Score

Argentis A-Score Model

Mistakes
High leverage Overtrading: company expanding faster than funding; capital base too small for level of activity, or capital base unbalanced for type and nature of the business. Big project that has gone wrong; any obligation that the company will be unable to meet if something goes wrong. Mistakes Scoring 15 15 15 45

Symptoms of Trouble
Financial analyses appear to indicate failure or difficulties (e.g. poor Z-score) Creative accounting Any non-financial signs of problems: uncleaned and untidy offices and factory, high turnover in human resources, low moral, rumours, etc. Symptoms Scoring 4 4 4 12

Total A Score

100

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The Turnaround Process

Environmentalscanning: Spottingthreats andopportunitiesthatmaycomplicateor facilitatetheturnaroundprocess.

Porters 5 Forces Model

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The Turnaround Process

Takingstock:Whatresourcesdowehaveto

workwithandwhatcriticalresourcesare missing?

Shifting the Focus of Strategy Analysis: From the External to the Internal Environment
THE FIRM Goals & Values Resources & Capabilities Structure & Systems THE INDUSTRY ENVIRONMENT

STRATEGY
STRATEGY

Competitors Customers Suppliers

The Firm-Strategy Interface

2010 Robert M. Grant www.contemporarystrategyanalysis.com

The Environment-Strategy Interface

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The Links between Resources, Capabilities and Competitive Advantage

An organizational capability is a firms capacity to deploy resources to achieve a desired end result.

A distinctive capability describes those things that an organization does particularly well relative to its competitors.

The Turnaround Process

Assimilation: Theprocessofingestingand digestinglargeamountsofdataand information.

N.B.Itisintheinterpretationofthisinformation thattherealartofleadershiplies.

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Identifying Key Success Factors

Pre-requisites for success
What do customers want? How does the firm survive competition Analysis of competition Analysis of demand Who are our customers? What do they want? What drives competition? What What drives are thecompetition? main dimensions What are the main of competition? dimensions of competition? How intense intense is is competition? competition? How How can we obtain How can we obtain a a superior superior competitive competitive position?position?

2010 Robert M. Grant www.contemporarystrategyanalysis.com

KEY SUCCESS FACTORS

The Turnaround Process

StrategyFormulation:"Whatif?"Modeling.Target Selection.Chartingthecourse.

FacilitationMechanism InteractiveWhatifModels
.thisprocessofdatagathering,hypothesistesting,reflection,strategiclearning, andadaptationisfundamentaltothesuccessfulimplementationofbusiness strategy.

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What if? Modeling

Year Year 2011 Actual Year 2012 Actual Year 2012 What If?

Ratio Analysis
Working Capital Total Assets Retained Earnings EBIT Shareholder's Equity Total Liabilities Sales

2010 Actual

Z-Factor Variables
100,000 400,000 75,000 65,000 180,000 220,000 457,000 90,000 450,000 95,000 80,000 200,000 250,000 460,000 80,000 500,000 90,000 70,000 190,000 310,000 445,000 100,000 475,000 100,000 95,000 205,000 270,000 445,000

Altman's Z-Score ( Private Manufacturing)

Working Capital / Total Assets Retained Earnings / Total assets EBIT / Total Assets Shareholder's Equity / Total Liabilities Sales / Total Assets Altman Z-score 0.717 0.847 3.107 0.42 0.998 0.179 0.159 0.505 0.344 1.140 2.327 0.143 0.179 0.552 0.336 1.020 2.231 0.115 0.152 0.435 0.257 0.888 1.848 0.151 0.178 0.621 0.319 0.935 2.205

2013RobertM.Grant www.contemporarystrategyanalysis.com

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http://www.charlierose.com/view/interview/11983

Can you prevent corporate failure?

Yes, as long as you act early enough!

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Thank You

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