Macro
Approach To
Detection
and Prevention of Corporate Insolvency
(The Determinant Factors)
By
Enyi
Patrick Enyi (ACCA, ACA, MBA)
Madonna University, Okija - Onitsha
Anambra State, Nigeria.
TITLE of PAPER: A
“MACRO” APPROACH TO DETECTION AND PREVENTION OF CORPORATE INSOLVENCY
(The Determinant
factors.)
ABSTRACT
The application of financial analysis tools such as current, quick, and fixed assets ratios, creditors cover and liquidity index among others have not helped in stemming the rising rate of insolvency and business liquidation owing mainly to the fact that these tools are inadequately equipped to highlight futuristic financial problem spots. A normative research carried out on moribund business organizations in Nigeria aimed at finding the reasons for their inability to detect futuristic financial problem spots and proffering solutions thereon reveal that there are factors other than immediate liquidity considerations which also affect the “going concern” position of a business in the long run. It also revealed that every business has its operational point of perfection, which stands as its financial homeostasis and that three main variables (product mark-up ratio, technical efficiency level, and the cost of operating a production cycle) are necessary for proper estimation of working capital adequacy. The study made use of the experimental and survey research methods for internal and external validity tests respectively. It recommends the application of an advanced working capital “formula” derived from this study for estimating the most appropriate level for a firm’s working capital base, as well as predict organizational life-span and evaluate future projects more objectively.
INTRODUCTION
The
last 20 years witnessed a spate of entrepreneurial turbulence unprecedented in
the more than 40 years history of business entrepreneurship in independent
Nigeria. The rate at which business
sprang up and go under was and is still of much concern to the average
discerning entrepreneur. Worst hit in
this wave of financial misfortune are banks and their hapless
depositors/customers. According to Business
Times vol.6 No 12, 2002, as much as 5 banks are currently listed as
distressed and could be liquidated any moment.
The cause of course is Insolvency.
The
first stage in liquidation starts with insolvency. For clarity we define
insolvency as the inability of an
organization to meet the demands of its maturing current or long term liabilities
owing to lack of liquid funds. It is
obvious from the job descriptions of business managers that they are
responsible for the detection and prevention of insolvency in their firms. The
ability to do this lies squarely on how the firm’s working capital resources is
managed (Enyi 2002).
Sellers et al (2002) in analysing the decisions of Canadian courts on insolvency tried to distinguish between corporate insolvency, liquidity and balance sheet insolvency defined insolvency thus:
- a corporation has ceased
meeting obligations as they generally come due;
- the property of the corporation at a fair value is not sufficient to enable payment of all obligations due and accruing due.
Thus, the first type of
insolvency, they referred to as “corporate
insolvency”, the second, they tagged “Liquidity
insolvency” and the last they called “Balance
sheet insolvency”.
Doetsch and Hammer (2002) identified another type of insolvency which they called “Cross Border Insolvency”. Cross Border Insolvency according to them exist where transnational firms are unable to generate sufficient revenue to satisfy their debt obligations. Their financial distress then creates a situation where assets and claimants are scattered across more than one country.
To
manage working capital along line
entrepreneurial objectives, finance and business activity controllers employ
the use of tools such as ratio analysis, forecasting and budgetary controls,
among others. These tools combine to
give the business managers historical as well as predictive information, which
they need for their day-to-day job of making survival decisions for their
organization. The ability to get the
right information at the right time and to take the right decision where and
when if matters most confers a big advantage on the firm over its peers and go
a long way to determine the eventual survival and success of such an
organisation.
The
main problem facing business managers and that which this paper aims to tackle
is of course, the usual lack of the right information at the right time and
most likely too, the absence or non-existing predictive information generation
tool such as the one that could reveal futuristic financial problem spots. To
buttress this latter assertion, a look at the current financial analysis tools
will point out the obvious defects in them.
Information
relating to business survival and insolvency are normally derived using the
following ratio analysis:
1. Working Capital Ratio: This is a
loose measure of capital adequacy or insolvency, which considers the totality
of current assets as against the totality of current liabilities existing at a
particular point (VanHorne 1977)
2. Quick (Acid Test) Ratio: This is a
tighter measure of capital adequacy or insolvency, which considers only cash
and near cash assets against the totality of current liabilities. This is what is currently and erroneously
referred to as the “Solvency Ratio”.
(This assertion shall be proved as we progress).
3. Fixed Assets Ratio: This ratio is
another loose measure of capital adequacy, which is intended to weigh the
available working capital against the totality of fixed assets apparently
hoping to measure the proportion of the firm’s working capital that is
available for servicing the fixed capital of the organization (Osisioma 1997).
Other
measures of capital adequacy include; Creditors Cover and Liquidity Index, which have little significance
in detecting especially, long term solvency of an organization. There are other measures associated with
working capital, which ostensibly are also intended to equip managers with
facts and data concerning the financial livewire of their organisation.
In
all, these existing tools are at best a kid’s
glove approach to working capital management. This is because most of them mainly lay emphasis on short-term solvency
as expressed in the relationship between available current assets and
their ability to offset current liabilities as they fall due. The present approach systematically ignores
the future requirements of the firm.
This situation is what can aptly be termed as the “micro” approach to
working capital management, and this particularly seemed not to realize even as
glaring as it is, that there is something, a powerful factor which determines
the extent of success and longevity of a business organization from the onset
and which continued to play a role throughout the life of the organization,
metamorphosing from one problem type into another in the all apparent response
to the dictum of economic and social manipulations. This obviously calls for a “macro” approach, which will look at
the entire working capital need of a firm in terms of the foreseeable size of
the firm’s activities given the organization’s initial level of technical and
managerial efficiency. This is the
missing link that this article intends to provide.
The first attempt to, perhaps, suggest a more effective way of preventive business failure forecasting was in the works of Altman (1983) in which he used the discriminate analysis technique to calculate bankruptcy ratio. This ratio which uses the Z value to represent over all index of corporate fiscal health, is used mostly by stockholders to determine if the company is a good investment. The formula for the ratio is
Z = 1.2X1 +
1.4X2 + 3.3 X3 +
0.6X4 + 1.0X5
where
X1 = Working capital divided by total assets
X2 = Retained earnings divided by total assets
X3 = Earnings before interest and taxes divided by total assets
X4 = Market value of equity divided by the book value of total of total debt.
X5 = Sales divided by total assets.
The range of the Z-value for most corporations is between -4 and +8.
According to Altman (1983), financially strong corporations have Z values above
2.99 while those in serious trouble have Z- value below 1.81. Those in the
Middle are question marks that could go either way. The closer the firm gets to bankruptcy/insolvency, the more accurate the Z value is as a predictor.
A critical look at the components of the Altman’s Z value formula and the interpretations reveal that, though the Z-value ratio is a milestone in the prediction of corporate insolvency, it suffers in precision and is likely to mislead the user unless, and off course, the corporation under analysis has already reached the problem spot. Also, more confusing is the range of acceptable values, users would perhaps, have preferred Z-value set in fractions or percentages as these are more or less universal and better understood than the ones used. Though, Altman rightly included working capital, retained earnings and earning before interest and taxes in his analysis as these are the main, if not the only, determinants of corporate solvency, the inclusion of such items as market value of share and total sales serves little or no purpose in the determination of the corporate solvency. This is because you can make billions of Naira of sales and yet record losses; and as posited earlier, it is profits that fuel continued cash flow, losses only dwindle them. In the same vein, the market value of a company’s share is external and has nothing to contribute to either profitability or cash flow. Hence, the inclusion of these two in the analysis only goes further to confuse the consequent Z-value outcome.
Business solvency revolves primarily at the working capital base of the organization, the fixed assets are only called upon at the critical but more agonizing stage of dismemberment when the death throws have already set in. The objective of any predictive function is to fore warn about a situation so that it can be avoided or taken advantage of. When this is lacking in a tool, then the tool becomes ineffective. Nevertheless, Altman’s work is still a very useful reference point in the analysis and study of business insolvency.
Capitalization
The foundation of all business
enterprises lies on the capital base of the organisation. In fact, the business organization is as
large as its capital base and as strong as its earning capacity (Enyi 2002).
Capital can be defined as the amount set-aside for the establishment
and running of a business organisation. To the economist, capital is a resource set aside for the production
of future goods and other resources, (Samuelson 1980:45).
Osisioma (1997) identifies the
two types of capital as fixed and circulating capital (the latter we commonly refer to as working capital). Whichever
types of capital a business has, matters much less to the survival of the
business than the adequacy of such capital and how they are managed. He
stated that while the investor will be primarily interested in the fixed
capital of an enterprise, the creditors will attach more importance on the nature
and adequacy
of the firm’s working capital as this is the area that bothers on whether and
how they get paid.
The American Accounting Research
Bulletin No. 43 in Osisioma (1997) defined Working capital as a
“margin or buffer for meeting obligations within the ordinary operating cycle
of the business”.
Working Capital Management.
VanHorne
(1977) described working capital management as the administration of current
assets in the name of cash, marketable securities, receivables and inventories
whilst Osisioma B.C. (1997) defined it as the regulations, adjustment and
control of the balances of current assets and current liabilities of a firm
such that maturing obligations are met, and the fixed assets are properly
serviced.
Working Capital Adequacy
To be adequate, working capital must be
supplied in Desirable Quantities while maintaining Necessary
Components. The size of a firm’s working capital is
determined by a number of critical factors.
The first being the size and scope of the business operations. The adequacy of any working capital is
closely tied to the size and scope of the organization’s operations. Other factors that determine adequacy
include the length of the production cycle.
For the purpose of this article, we shall promptly refer to the “Production
cycle” mentioned within the preceding paragraphs henceforth or
interchangeably as “production run” or production trial”. Hence, a production run is hereby defined as
The lowest recognizable periodic
division of an organisation’s production and marketing activities which can be
quantified on the basis of cost and income, upon which budgets and projections
can be prepared.
For
elaboration, if a firm produces 100 articles per day from a cycle of 20
production activities, this will give 5 articles per production. It may just suffice to say that one
production run makes up to 5 articles, however; this may not be ideal as there
are some costs that follow defined periods.
E.g. wages; and apportioning them to each production cycle may be a bit
misleading. The most ideal thing to do
would be to aggregate all productions and cost for one day and treat them as “one production run”.
The
liquidity approach is the most effective way of measuring working capital
adequacy in the short run; this of course, is the universal approach. However, with liquidity defined as “ability
to realize value in money....”, (Van Horne 1977); we should concern
ourselves with the continued promotion of the “going concern”
principle for the organization by choosing a MACRO approach towards the firm’s working capital requirements
rather than the micro method. This is
the net-investment approach.
A
measure of working capital adequacy which uses the net-investment approach and
particularly avoiding all static components should strive at a position which
adequately pinpoints the actual working capital requirement of the firm at any
future point in time, given present and any future projected changes in the
firm’s activity level, as well as the inflationary trend of the economy. This is because management and investors are
more concerned with future periods than with the present and past. A more suitable measure should include a
system that will take into consideration the past and present (as a guide) and
the future (as a plan) to arrive at its result. This is the area where the
existing solvency measurement tools have grossly been found wanting.
Learning Curves
C.T.
Horngren (1982) in his words defined Learning Curve as “a cost function where average
costs per unit of output decline systematically as cumulative production
rises”. The connection between learning curve and working capital
management stems from the fact that faulty productions owing to inexperience
adds to costs in the same way as the longer time it takes a new comer to a task
which results in higher wage payments than when such tasks were undertaken by a
highly experienced worker.
More
so, a study on the capital adequacy of small firms indicated that loses arising
from the cost of learning do, in fact, contribute to capital depletion. The
longer the period of learning, the higher the cost associated with learning and
the more the organisation’s capital is depleted. How badly this will affect the organization will depend, to a
large extent, on the rate of cost/loss recovery as expressed in the
pricing/marketing ability of the organisations goods and services.
Of course, it will take an
organization with a lower price-to-cost mark-up ratio much longer period to
fully recover costs and losses associated with the learning period than it
would take a similar organisation with the same learning period but with much
higher mark-up ratio. Thus, the costs
and losses associated with the learning periods can adversely affect the solvency
of an organisation when:
Ø
The learning period is unusually long and/or the mark-up
ratio is too low to hasten recovery of cost and learning losses;
Ø
The learning period is
short but no adequate capital to continue production and enhance the recovery
of costs and learning losses or a combination.
METHODOLOGY
Two
research methods were employed in this study and these are (a) Experimental
Research and (b) Survey Research. Two companies were used in the form of case
studies for the experimental aspect while 18 others (Appendix A) were selected
randomly for the external validation test survey. Questionnaire and oral
interview were used to collect research data. The first case study company, a
bakery was situated in Kano. It started bread bakery business in January 1984
and folded up 4 months after. The second company, an alcoholic beverage
manufacturer situates in Anambra State and still exists till date. It was
studied between 1993 and 1994.
CASE
STUDY DATA: CASE 1 CASE 2
N N
Commencement
Capital 115,000 N/A
Fixed Costs
Expenses 83,000 N/A
Working
Capital Available 32,000 984,000
Additional
Working Capital (Bank O/d) - 2,000,000
Cost of One
Production Run 4,000 452,000
1st
Production Recovery 500 90,400
2nd
Production Recovery 1,000 180,800
3rd
Production Recovery 1,500 271,200
4th
Production Recovery 2,000 361,600
5th
Production Recovery 2,500 452,000
6th
Production Recovery 3,000 452,000
7th
Production Recovery 3,500 452,000
8th
Production Recovery 4,000 452,000
9th
to 18th trials revealed the same pattern as the 8th
production run.
Source: Production and Sales Activity records
of the 2 companies.
The first problem to confront the bakery company was the inefficiency of the sparsely skilled hired workers that resulted in a lot of damages and materials wastage. This problem cost the company one full day’s production owing to the high perishable nature of bakery products. This loss resulted naturally to the firing of the production staff and the engagement of new hands.