PREDICTING FAILURE

OVERVIEW

Objective

! To discuss corporate failure and the impact of this on strategic planning.

CORPORATE
FAILURE

PREDICTING STRATEGIC
FAILURE REVIEW

! Limitations of ratios ! Periodicity

! Failure indicators ! Dynamic environments
! Z-scores
! Applying z-scores
! Icarus

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1 PREDICTING CORPORATE FAILURE

1.1 Introduction

Corporate failure defies precise definition (Altman, 1989).

Causes and symptoms of failure, as will be seen later, come in various forms and it is
up to management to deal with each situation as it arises.

Financial failure occurs when the enterprise has chronic and serious losses or when the
firm becomes insolvent with liabilities disproportionate to the assets. The generally
accepted reasons for corporate bankruptcy are poor management, autocratic leaders,
failure to operate successfully in the market place, or inability to pay debts when due.
These factors have all been implicated in the collapse of many companies.

1.2 The limitations of ratios

Altman et al, (1990) in their study point out that the following are some of the pitfalls
of financial accounting ratio analysis:

! Ratio analysis are based on historical data which are only relevant to the
period under investigation. They are therefore common-size reductive
devices which allows analysts to reduce both extremely small and large
financial data to lowest numbers or multiples. For example, a comparison of
£345, 678 to £567, 902 would be expressed by the ratio 0.6. Ratio analysis
simply summarises but is not capable of generalising (Argenti, 1975).

! The grouping of ratios and their interpretation is time consuming and costly.
The interpretation would normally be done on a piecemeal basis by human
experts because human experts lack the capacity to interpret financial trends
over say, a five year period all at once. This daunting exercise makes
analysts slow thus forcing management to employ more external professional
staff to handle financial information thus increasing the cost of granting
credit.

1.3 Failure indicators

It is clear that there is no one single cause of corporate failure. Many factors have been
implicated in the collapse of major companies or in the need for restructuring and re-
organisations. Often these factors occur in combination with one another. However,
given the complexity of business operations and influence of the external environment,
a simple model which considers these factors as predictors of corporate failure is
unlikely to be reliable. Indeed, if it were that simple, techniques such as ratio analysis
and multivariate analysis would be adequate.

1.4 The Z-score model (Altman)

Altman (1968) improved on Beaver's univariate method of analysis by introducing the

multivariate approach, which allows for the simultaneous consideration of several

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variables in the prediction of business failure. The approach is that of the multivariate
discriminant analysis (MDA). Discriminant analysis is a statistical technique used to
construct classification schemes so as to assign previous unclassified observations to
the appropriate group. Altman based his work on groups of appropriate financial
reports extracted from company accounting statements.

1.5 Applying the Z-score model

Z = 0.012X1 + 0.014X2 +.0033X3 + .006X4 + .999X5

In which Z = the overall solvency index and

X1 to X5 are the independent variables. (ie the ratios)

X1= Working Capital

Total Assets

X2= Retained Earnings

Total Assets

X3= Earnings before interest and tax

Total Assets

X4= Market value of Equity

Total Debt book value

X5= Total Sales

Total Assets

Altman used a MDA programme to calculate the numeric values as shown above. The
Z values were used to classify firms as either bankrupt or non bankrupt. Where the Z-
score was below 1.81, the firm was considered to be failing; where it was above 2.99 it
was healthy.

It was soon noted, however, that the differences between market capitalisation of US
corporations and UK counterparts varied significantly to make Altman's original model
predictively inaccurate when applied to UK companies in the same sector. These
results were later shown by Beaver (1966) to be less suitable under conditions different
from those used by Altman.

Bathory (1984) found that Altman's model could not be applied to UK based
companies and this led to further research being carried out.

1.5 Strategic drift – the Icarus paradox

Recall the Greek story of Daedalus and Icarus. The father, Daedalus, invented flight by
gluing bird feathers to the back and arms of himself and his son, Icarus. Icarus, taken
by his new ability flew too close to the sun, which melted the wax glue, and he fell to
his death. The moral: don't go too far with what you're good at.

This story characterises a fatal flaw in many leaders and organisations: they exaggerate
a strength to a fault.

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The Icarus Paradox: Miller (1990) proposed that many companies becomes so dazzled
by their early success that they believe more of the same type of effort is the way to
future success. The four categories of these companies are: craftsmen (concentrate too
much on engineering excellence), builders (diversify), pioneers (innovations), salesmen
(marketing)

After lengthy intervals of continued success, firms exhibit increased inertia and
insularity and fail to adapt to changing environments. Not only do resources
accumulated over time buffer the organisation from variation in the environment
(reducing the perceived need for change), but also the open and eager commitment of
powerful leaders to what have been proclaimed to be successful policies, makes
challenges by lower ranking members in the organisation less likely, even if the latter's
position “in the field” or “at the heart of the action” might uniquely qualify them to
offer such a critique.

Consider IBM and the losses it endured early this decade. Despite being the inventor
of the personal computer, IBM sat back and allowed others to reinvent that industry,
losing control over the direction and pace of technical change. “Big Blue went into
denial, channelling its massive resources into bucking the market rather than facing it”
(Economist, 6 June 1998, p. 66). Not only did it lose talented people, but the loyal
who remained were frustrated and disheartened. The radical transformation required
and eventually implemented by Lou Gerstner was in fact an organisational “cultural
revolution” (Allaire and Firsirotu, 1985) that revised the assumptions, terminology, and
normative aspects of organisational discourse at the highest levels of the cognitive
hierarchy (doctrine and ideology). “Products” became “services” and “sales” became
“solutions.” The newly empowered Global Services division acts as an efficient
intelligence and information gathering mechanism, “out there” with customers and
having an incentive structure encouraging brutal honesty when IBM products do not
meet its clients' needs.

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2 STRATEGIC REVIEW

2.1 Introduction

One of the ways to avoid, or at least lessen the risk of, corporate failure is to revise the
strategy.

2.2 Periodicity

There are many different arguments about how frequently a strategic plan should be
revised. In many organisations, planning is an annual process that is carried out
towards the end of the financial year and the first year of the plan becomes the next
year’s budget. This approach seems flawed for two reasons:

! Strategic variables do not conveniently change on an annual basis

! Knowing that they will be translating the strategic plan into a budget leads
planners to concentrate on the financial aspects of the plan and ignore the
qualitative (and often more strategically significant) aspects.

2.3 Dynamic environments

Because of the rate of change in the business environment, a number of different

approaches have been developed to cope with the problem of obsolescence in planning.
These are:

! Adaptive planning
! Interpretative planning
! Contingency planning
! Chaos theory

Each of these is outlined below.

2.3.1 Adaptive planning

Adaptive approaches to strategy formulation suggest that the organisation should be

continually on the lookout for changes in the strategic business environment, and
should change their plans as key variables change.

2.3.2 Interpretative planning

Interpretative planning suggests that the organisation should try to predict changes in
their environment and plan in advance of them.

2.3.3 Contingency planning

In this approach, the organisation prepares a number of plans, each based on a different
scenario or relating to a specific “contingency” or possible event. The most
appropriate plan, or plans, is then implemented and the remainder discarded.

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2.3.4 Chaos theory

In Thriving on Chaos, Tom Peters suggested that , due to the chaotic nature of the
business environment, organisations should plan to be equally chaotic. His view (and it
is somewhat extreme!) is that organisations should “destroy and reinvent themselves
every day”.

FOCUS

You should now be able to:

! understand indicators of failure

! discuss Z scores: Altman

! assess strategic drift: the Icarus Paradox

! analyse weak or inappropriate strategic leadership.

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