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Corporate Failure

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CORPORATE FAILURE

Why do companies fail?

Over the last 25 years, many businesses all over the world have gone under. Some of these companies include Oceanic Bank, Intercontinental Bank, Enron, and WorldCom etc. A lot of excuses have been used to try to explain why some of the most talked about companies went under.

Various schools of thoughts have blamed the demise of these institutions on different things such as;

  • The stock market bubble
  • Poor accounting practices
  • Outright fraud

This write up will nevertheless try to identify why companies fail while subsequent write ups will try and set out what the prudent investor, board member or manager should be aware of but often take for granted.

The reasons for company failures are few and they are common to most of the companies irrespective of the industry they belong to or where they are located geographically.

Following various studies, it is believed that the main causes of failure for companies and corporations can be grouped into six categories vis-à-vis;

  1. Poor Strategic Decisions
  2. Over-expansion and Ill Judged Acquisitions
  3. Dominant Chief Executive Officers (CEOs)
  4. Greed, Hubris and the Desire for Power
  5. Failure of Internal Controls at all Levels from the Top Downwards
  6. Ineffectual or Ineffective Boards

Poor Strategic Decisions

  • Research has shown that companies often fail to understand the relevant business drivers when they expand into new products or geographical markets
  • As such, they lack the appreciation of the major risks management principles that are needed to manage the business in those new areas.
  • Many a times, they do not carry out adequate due diligence when making the decisions for going into a new business area.

Over-expansion

  • Due to the frustrations for companies to grow organically sufficiently and quickly, they often turn to mergers and/or acquisitions. Statistics has proved over the years that over 50% of such transactions fail to deliver the expected results.
  • So often, with this mergers of strange bed fellows, cultural differences and the lack of management capacity adds to the problems which lead to failure
  • Also many companies pay too high a price in securing the deal thereby stretching their capacities which could result in additional difficulties for the businesses to meet cash flow expectations
  • Various researches have shown that overexpansion by way of acquisition is driven by the presumptuous goal of short term growth, especially where companies are focused on headline revenues.
  • Finally, acquisition and/or mergers are not primarily a bad idea, however where they have been carried primarily to boost growth rates over a number of years, they have become more difficult to achieve the same effect. This is because the possible targets decreases, whilst prices paid and the level of risks rise much more quickly than the anticipated growth.

Dominant CEOs

  • Dominant CEOs come about as a result of a period of perceived successful management. As such, the businesses become packed with like-minded executives who owe their position to the CEO and as such are reluctant to challenge his/her judgment.
  • As a result, the Board could become complacent as they are lulled by past achievement, thereby failing to check and scrutinize detailed performance indicators and fall into the habit of rubber stamping the CEO’s decisions.
  • Though the CEO has accomplished a lot with his/her brand of management style, as they go on in the business, they become a major contributor to the business’s downfall.
  • Many a times, as there are less challenges or criticism with the business, the dominant CEO will begin to (sometimes unconsciously) behave as though it his own creation (even if it was) and as such use it as his own piggy bank thereby making shareholders and directors irrelevant, as they are seduced by the prospects of yet more power and wealth and with a strong belief in their own infallibility.

Greed, Hubris and a Desire for Power

  • Naturally people tend to be greedy and are rarely content with what they have achieved.
  • High achievers, such as top executives are particularly ambitious and are eager for more power and wealth. Since there is clear, positive correlation between size of a corporation and executive compensations and status, CEOs have every incentive to grow their companies. As already stated that acquisition is one of the quickest ways to grow a business, many CEOs need little encouragement to go on a spending spree especially where they have no checks from the Board.
  • Also to note is the fact that it is not only CEOs that are driven by greed. With the incentive bonuses now being a major part of the remuneration and it being tied to short-term results, there will always be a temptation to massage the figures in order to raise pay.
  • The value attached to status and wealth drives persons in organizations to excel and in some cases to cook the books.

 

Failure of Internal Controls

  • Internal control deficiencies are often compounded by complex or unclear organizational structures
  • Blurred reporting lines leave gaps in control systems that could be exploited by members of the organization
  • Dispersed departments can also add to this problem. This can happen where departments fail to work together closely in order to pool the knowledge of the activities in different areas of the business.
  • Lack of efficient internal control systems, could lead to biased decision-making where CEOs rely on a small clique of insiders (not all the most senior personnel) to discuss strategy.
  • Changing the organizational structure can often leave gaps in information flow and responsibilities until the new structure matures. Where this happens, vital data can be overlooked.
  • Remote operations which are far from the Head Office are often difficult to manage. As a lot of emphasis is placed on the local management, it is difficult to judge if the correct and sufficient information is being sent to Head Office. This is particularly a problem with new, or unfamiliar, operations that are new to the Executives in Head Office.
  • Another fundamental contributor to failure is a weak, or ineffective, internal audit function. Many a times, this is regarded as an expensive and unnecessary overhead. As such the functions are understaffed, and have chosen, or been forced to perform mostly operational audits with the objectives of uncovering potential cost savings rather than financial audits with the objective of safe guarding the assets of the company.
  • Internal audit independence functions are greatly undermined today when it reports solely to the CEO or CFO or when the audit programme, findings and employee remuneration are dependent on the CEO or CFO.
  • Where there is huge deficiency in the area of cash control. This happens where most organizations believe that revenue generation is more important than collecting the debts accrued from sales.
  • Finally from various research and findings, it is believed that a CFO without a professional accounting qualification is a significant additional risk factor. Without trying to discredit bankers and MBA holders, many a times they don’t have the broad range of skills to oversee the finances of large companies and certainly not the very complex companies.

Ineffective Boards

  • When you look at a lot of the business that have collapsed since the beginning of the new millennium, we can see a lack of genuinely Independent Directors.
  • A Board should provide a non-partisan judgment of senior management’s actions and strategic proposal to look after the interest of all stakeholders.
  • Directors who are financially beholden to the company (other than by way of proper compensation for being a Director) are a key risk as their judgment may well be clouded
  • Many of the so called Independent Directors may not have been so independent after all.
  • Where the role of Chairman and CEO is combined, this poses a big threat to the independence of the Board, as one of the key tasks of the Chairman is to assess the performance of the CEO in the running of the company
  • There is the need to have a competent Audit Committee to help ensure that the books of the business present a true and fair view of their affairs. Many of the Audit Committee members have too little financial expertise, thereby making it difficult for them to understand complex accounting matters.
  • All around Europe and America, but also becoming rampant in African businesses today, the rising of share prices and earnings may have lulled boards into thinking that all was well, and that management was doing a good job.
  • Many boards have continually failed to question management; failed to assess their competencies, spent far little time in Board meetings and deliberations; allowed executive compensations to spiral out of control; and accepted management figures and explanations without serious questions.

Finally, it is obvious that these six reasons for the failures of businesses and companies are the main attributes that lead to frauds, stock market collapses and outright poor accounting practices in companies which have collapsed all over the world.

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