Why Companies Fail: Strategies for Detecting, Avoiding, and Profiting from Bankruptcy

A revealing presentation of the causes of business failure and the strategies for avoiding bankruptcy and liquidation.

This revealing book is a straightforward presentation of the causes of business failure and the strategies for steering a troubled company away from the threat of bankruptcy and liquidation. Five major financial traps that can lead to failure are identified, and each trap is illustrated with actual cases of well-known companies. Distressed companies are offered hope with examples of asset, liability, and corporate maneuvers that can help guide failing businesses to firmer ground.

A business fails every hour of every day in the United States. Why? What kinds of problems have these businesses run into? And what steps can corporate executives and managers take to avoid the same fate for their own companies?

Why Companies Fail answers these questions and more, in a straightforward presentation of the causes of business failure and the strategies for steering a troubled company away from the threat of bankruptcy and liquidation. Author Harlan D. Platt identifies five major financial traps that can lead to failure, and illustrates each trap with actual cases of well-known companies, including Wickes, W.T. Grant and Braniff. Dr. Platt offers distressed companies hope, too, with examples of asset, liability and corporate maneuvers that can help guide failing businesses to firmer ground.

Originally published in 1985, Why Companies Fail remains a useful, simple guide for the average businessperson to identify and avoid the traps that lead to bankruptcy. Noting that libraries are full of books containing prescriptions for financial success, the author chooses to focus on failure so that it can be avoided and the number of bankruptcies reduced. He also feels the book fills a gap in the education of students and business people who are not otherwise instructed in how to manage a company on the brink of failure. To aid in understanding his analysis, he classifies businesses into four categories depending on the strength or weakness of their product and their financial condition, calling them eagles, tortoises, condors, and dinosaurs. As he explains, "[e]agles have healthy products and finances, tortoises have weak products, condors have weak finances, and dinosaurs have weak products and finances," Condors and dinosaurs are the primary focus of the book, since financial issues lend themselves more to generalization.

The five chapters that are the heart of the book set out the specific financial reasons for business failure, any or all of which could precipitate the bankruptcy. Each contains actual cases of companies to illustrate the type of problem. Problems in a company's cash-flow cycle are discussed in Chapter 3. The author opines that mismanagement in this area is probably the largest single cause of failure, but maintains that staying on top of the problem can be accomplished with a good spreadsheet program and that with the proper information "every worthy business" should be able to obtain the funds it needs. In Chapter 4 the topic is how to avoid "getting buried under current assets." The advice here is to monitor both inventories and accounts receivable by comparing their size to the company's investment in total assets and to analyze carefully when that ratio rises whether that is the desired goal. In Chapter 5, entitled "Getting Squeezed by Equipment," the author can only warn of the risks involved in investing in long-term assets. He concludes: "Unfortunately, there are no fail-safe methods for choosing the right amount of fixed assets since the optimal quantity depends an the unknown level of future sales." Chapter 6 deals with a company's debt-to-equity ratio, emphasizing that a major disadvantage to debt financing is that it limits alternatives, and a firm so burdened is allowed fewer mistakes than one with sizable net worth. In Chapter 7, entitled "Getting Pinched by Short-Term Debt;" the author describes the trap where management decides to speculate on lower future interest rates and is wrong.

Chapter 8 sets forth methods of detecting bankruptcies to enable the reader to identify the condors, and Chapter 9 aids failing companies by an examination of how other companies in similar situations have extricated themselves. Chapter 10 contains advice on investing in bankrupt companies. Following a concluding chapter summarizing his concepts, the author includes two appendices, one setting forth tables of failure rates, which, of course, does not include what has happened in the last fourteen years, and the second providing basic accounting for nonfinancial readers. A glossary is also included for those whose background in the field is limited.

The book is written for those who may not be trained in finance or accounting but who need to understand the obstacles responsible for most business failures. Recommended for both the general and academic reader, community college level and above.

This book, written for the nonfinancial reader, records conventional reasons for business failure: cash-flow problems, taking on too much debt, and starting out with too little capital. But it continues where other books may stop, pointing out to those who are nearly bankrupt how to avoid bankruptcy. It describes reorganization techniques that have pulled companies out of the holein recent years--such as refocusing market niches and converting debt into stock. The book uses minicases to illustrate these methods. The author also gives potential investors a score card to select potential turnaround companies when picking up the high-risk, high-yield bonds (not stocks) of near-bankrupt or bankrupt companies.

Harlan D. Platt is Professor of Finance in the College of Business Administration at Northeastern University. He is the author of two other books, The First Junk Bond an Principles of Corporate Renewal, and has published over 35 academic articles. Professor Platt is also the faculty dean of the Turnaround Management Association, where he created and administers its certification program. He serves on the board of directors of Prospect Street High Income Portfolio, Inc., listed on the NYSE, and VSI Enterprises, Inc. on the NASDAQ, and is president of 911RISK, Inc. a firm specializing in developing analytical models that predict corporate distress.

	Figures	xi
	Tables	xii
	Preface and Acknowledgments	xvii

1.	Challenging the Propensity to Fail	1
	Characterizing Business	2
	Characterizing Failure	6
	The Route away from Failure	9
2.	Financial Reasons for Failure	13
3.	Getting Caught in the Cash-Flow Cycle	17
	Charter	20
	Lionel	21
4.	Getting Buried under Current Assets	29
	Bowmar Instruments: Too Many Current Assets	31
	W.T. Grant: Too Many and Then Too Few Current Assets	34
5.	Getting Squeezed by Equipment	37
	Braniff Airways	43
	International Harvester	44
6.	Getting Lost with Too Little Capital	51
	Comparing High Debt to High Equity	53
	Comparing Debt Levels across Firms	56
	Deciding When There Is Too Much Debt	57
	Dome Petroleum: Waiting Too Long to Sell Stock	59
	Computer Devices: The Case of David against Goliath	62
7.	Getting Pinched by Short-Term Debt	69
	Interest for Risk: The Yield Curve	69
	Ten Steps to Bankruptcy	72
	Wickes	73
8.	Detecting Future Bankruptcies	81
	Using Common Sense	82
	Detecting Failures with Financial Ratios	84
	Statistical Methods	88
9.	Strategies for the Near-Bankrupt	93
	Strategies That Might Help	94
	Asset Maneuvers: Storage Technology, Pan American Airways, Crompton	95
	Liability Maneuvers: Mattel, Chrysler, Sonoma Vineyards, Astro Drilling, Holywell	97
	Company Maneuvers: Eagle Computer, Farah Manufacturing, Frontier Airlines, Wien Airlines, Data Terminal Systems	102
10.	Investing in Bankrupt Companies	107
	Three Rules for Bankruptcy Investing	107
	Using Portfolios	110
	Choosing Which Bankrupts to Buy	110
11.	Conclusion	115
	The Lessons of Bankruptcy	115
	The Strategic Use of Bankruptcy	116

	Appendix A: The Failure of Record	119
	Appendix B: Basic Accounting for Nonfinancial Readers	129
	Notes	137
	Glossary	139
	Bibliography	141
	Index	143
	About the Author	149

FIGURES
1-1.	Classifying Companies Based on Product and Financial Well-Being	3
3-1.	Balancing the Cash-Flow Cycle	19
3-2.	Profits and Losses for a Seasonal Business	23
4-1.	Asset Mix	31
5-1.	Comparison of High- and Low-Fixed-Cost Companies	39
5-2.	International Harvester's Capital Spending per Share of Common Stock	46
7-1.	Typical Yield Curve	70
7-2.	Determination of Interest Rates by Market Forces	71
7-3.	Perverse Yield Curve	72

TABLES
1-1.	Categories of Business Failure	6
1-2.	Texas International's 1983 Balance Sheet	9
1-3.	Outcomes of Financial Failure	11
1-4.	Priority of Bankruptcy Claims	12
3-1.	Typical Cash-Flow Cycle	18
3-2.	Changing Cash Flows with Four Managerial Choices	18
3-3.	Lionel's Quarterly Income Statement since Filing Chapter 11	25
3-4.	Lionel's Second Amended Reorganization Plan	26
4-1.	Profitability and Risk Potential of Current and Fixed Assets	30
4-2.	Bowmar Instruments' Annual Sales and Inventory	33
4-3.	W.T. Grant's Sales and Income, Year Ending January 31	35
4-4.	W.T. Grant's Credit Data, Year Ending January 31	36
5-1.	Calculating the Cost of Increasing Output	40
5-2.	Calculating Break-Even Output by Using Contribution Margin and Cost	40
5-3.	Operating Profit/Loss	41
5-4.	International Harvester's Financial Data, 1975-1983	47
5-5.	International Harvester's Profit Margin	48
5-6.	International Harvester's Debt Restructuring Plan, December 15, 1983	49
6-1.	Methods for Raising Equity Funds	52
6-2.	Methods for Obtaining Debt Funds	53
6-3.	Balance Sheet for a Company Needing $1 Million	54
6-4.	Income Statement of a Firm Needing $1 Million	55
6-5.	Calculating Financial Leverage: Going from $625,000 to $750,000 in Revenue	56
6-6.	Measures of Indebtedness	57
6-7.	Dome Petroleum Data	60
6-8.	Dome Petroleum: Debt Affordability Measure	61
6-9.	Computer Devices' Financial Summary	62
6-10.	Computer Devices' Quarterly Profits and Equity, 1982 and 1983	64
7-1.	Wickes and Gambles-Skogmo: Profit Margin Comparison	75
7-2.	Analysis of the Gambles-Skogmo Acquisition	75
7-3.	Wickes's Short-Term Debt, Year Ending January 31	76
7-4.	Wickes's Income Statement, as of January 30	77
7-5.	Wicke's Debt	77
7-6.	Wicke's Reorganization Plan	78
8-1.	Commonsense Bankruptcy Detectors	83
8-2.	Optimistic Interpretations of Bankruptcy Signs	84
8-3.	Types of Financial Ratios	85
8-4.	Bankruptcy-Detecting Financial Ratios	86
8-5.	Changes in Financial Ratios Indicating Worsening Financial Condition	86
8-6.	Altman's Discriminating Ratios	90
8-7.	Altman, Haldeman, and Narayanan's Financial Indicators	90
8-8.	Pantalone and Platt's Key Savings and Loan Failure Indicators	91
9-1.	Using Assets in a Crisis	95
9-2.	Using Equity or Liabilities in a Crisis	98
9-3.	Refocusing the Company in Times of Crisis	103
10-1.	Returns from Bankrupt Stocks	108
10-2.	Returns from Bankrupt Bonds	109
10-3.	Characteristics of Good Bankrupt Companies	111
A-1.	Failures since 1925	120
A-2.	Average Failure Rates by Decade	123
A-3.	Number of Firms in 1950 and 1980 by Industry	123
A-4.	Average Failure Rate by Industry	124
A-5.	Variance of Industry Failure Rates	126
A-6.	Why 16,794 Businesses Failed in 1981	127
A-7.	Causes of Most Failures	127
B-1.	Prime Computer's 1983 Income Statement	130
B-2.	Prime Computer's 1983 Balance Sheet	133
B-3.	Balance Sheet Terms	134