Liquidation Assessment through Strategic Financial Statement Analysis - Essay Example

LIQUIDATION ASSESSMENT THROUGH STRATEGIC FINANCIAL STATEMENT ANALYSIS. Executive Summary This research proposal is aimed at studying the causes of the corporate failures resulting in their liquidation through the technique of strategic financial statement analysis. The research methodology proposed is an extensive literature review of history of corporate failures ever since the Great depression till the recent recession effects of which are still being felt. Besides, a literature on the principles of finance and the definition of ratios required for the analysis will be discussed. Apart from this secondary data, ten companies that failed and were liquidated recently will be selected and their financial statements analysed to pinpoint the indicators of vulnerable areas that led to their liquidation. Finally a model will be arrived for future use in predicting the corporate failures and the measures to make the companies immune to the possible recession or any abnormalities in the economy at the macro level. Table of Contents Sl No Particulars Page no Chapter 1 Introduction 3 Chapter 2 Literature Review 7 Chapter 3 Research Methodology 9 Chapter 4 Discussion and Conclusion 15 References 17 Chapter 1 1.1 Introduction The year 2009 witnessed liquidation of 19,077 companies as per the figures of the insolvency service representing an increase of 23% from the year 2008. and out of 19,077, 6,335 companies have been declared insolvent (Professional broking, 2010) According to Adam (2010) the figures are 13,434 as voluntary liquidations and 5,643 are compulsory liquidations totalling 19,077 as per the above report. Again in the UK, Red Flag Alert says that more than 140,000 were showing signs of financial distress in q4 2009. The figure is 6 % higher than Q3 2009 but 14 % lesser than the identical period in 2008. The corporate failures seem to unstoppable despite fiscal support by the Government, VAT reductions by 2.5% and the HRMC’s payment support for £ 4.2 bn covering 242,000 ‘time-to-pay arrangements’ (Begbies Traynor Group, 2010). The U.S.based Circuit City, second largest retailer of electronics next to Best Buy went into liquidation of its last retained store after series of one liquidation after another in early 2009 rendering their final tally of 30,000 of employees jobless. One commentator has said that it was a well deserved as a poorly managed company (Rolling Stone, 2009). Needless to say, recession has been responsible for this state of affairs. Recessions are considered a process of plumbing of economics that removes the inefficient entities and paves way for reallocation of capital and labour to the most deserving entities. The faster the reallocation, the safer the investments. The three ways in which insolvency is dealt with are liquidation, rescue and workout. Liquidation is the process administered by the court for sale of the assets of the insolvent firm in piecemeal. A rescue is again a court intervention for rehabilitation, reorganisation or restructuring of the insolvent firm with the objective of preventing its liquidation. A workout is the informal process where court has no role and the creditors either reschedule their debts or allow settlement of debts at a discount. Laws of the United States and western European countries allow both liquidation as well as rescue. Among these, the United States has more favourable laws facilitating hassle free liquidation or rescue. In the west, social stigma is associated with bankruptcy filing (Gamble, 1998). Perry (2008) states that recessions have Darwinian effects decimating the weak and strengthening the survivors even more. Practically, during the period of recession, strong retailers buy more mall space, high net worth banks are flooded with deposits and tech companies enjoy hassle free hiring. On the other hand, because of weak enterprises, 1.2 million jobs have been lost in the year 2008. Present day’s economic conditions are characterized by banks’ improper risk assessment under the conditions of credit being marketed as a product with all its attendant anxiety on the part of bankers to meet targets, credit agencies’ poorly studied rating of sophisticated debt instruments such as subprime mortgages and failures in the stock market. The closure of Lehman Brothers in 2008 has led to chain reactions down the line. These developments have made credit default move up by 4.5 % expected to reach double-digits in 2010, led to an increase of US Bankruptcy filings by 74 % (136 companies) and European insolvencies by 51 % characterised by 1 in every 150 trading companies being liquidated in the U.K. Other side effects are 3.6 million Americans have lost jobs ever since 2008 when the recession started, drop in real estate prices by 28 %, decline in consumer spending and stock market and poor tax collections. Unlike during the Great Depression, there is total lack of credit availability in current recession as the crises are bank led (Alvarez II, 2009) Except for the nondiscretionary sectors of healthcare, food etc, those hard hit by the recession are financial institutions, residential estate, automotive, advertising and media, retail, consumer electronics and hospitality industries (Alvarez 11,2009) According to Prof Reinhart of Maryland University and Rogoff of Harvard, real estate values have dropped by 35% in a five year period, equity prizes by 50 % in a 3.5 year period and heavy decline in production in a 2 year period and a 7 % rise in unemployment in a 4 year period (Reinhart and Rogoff, 2008). Adam (2010) states that company liquidations which are a logical end of an insolvent firm should be voluntary in order to avoid lasting effects for the directors provided they have not knowingly indulged in insolvent trading. In the case of a compulsory liquidation, it can have lasting effects on the directors. Jacobs (ND) reports that Lehman Brothers had been underreporting its debts by $ 5 billion by wiping off as much from the balance sheet at the times regulators and shareholders were scrutinising, sold it through ‘toxic sales’ and quickly buy them back later. 1.2 Problem statement The brief introduction shows that liquidation of companies can be due to variety of reasons. However mass liquidations happen when some thing has gone wrong at the macro level in an economy. The alarming situation outlined above prompts one to ponder how and why liquidations take place in spite of close monitoring by the enforcement authorities. Whether it is a logical process as suggested by Malthusian theory of population or it is a preventable one. The current recession is quite different from the earlier ones. Therefore it is proposed to undertake a study of liquidation of publicly owned companies during the recent past of the current recession. The countries chosen for the study are the U.K and the U.S.A which are the worst affected. 1.3 Aim and Objectives 1) To analyse the financial statements of as many as ten liquidated companies of the U.S.A and the U.K. from diverse sectors. 2) To ascertain why these companies failed in spite of continuous monitoring by the regulatory authorities and 3) To conclude whether the liquidation is preventable or is it a logical process whenever the recession occurs. 4) To arrive at a financial model for liquidation assessment without co-relational studies. 1.4 Research Questions What are the parameters to be applied in the assessment of liquidation of companies through Financial Statement Analysis? How to prevent liquidation of companies in the event of recession or downturn in the economy? 1.5 Originality This study will be original in several respects in that there is no published research relating to corporate failures of the recent past due to recession and the most of the existing studies on corporate failures are based on empirical testing and not based on qualitative research as proposed in the research methodology section below. 1.6 Conclusion The research will be qualitative as well as quantitative as a hybrid form of study. This proposal will have separate chapters on literature review, research methodology, data analysis and findings, conclusions and recommendations. Chapter 2 Literature Review Basically liquidation assessment involves investigation of determinants of corporate failures. In the United Kingdom, Bank of England has a continuing programme in place to research into adverse financial conditions of corporates in the U.K. with the use of micro-data as in Benito and Vieghe (2000).Reasons for corporate liquidations are understood by arriving at a stylised model of the firm. According to this stylised model, level of profits, indebtedness, borrowing constraints and inflationary trends. Certain determinants are taken variables and examined. Capital gearing ratios based on market value of assets do not indicate corporate failures as effectively as other ratios which can measure debts based on replacement cost of costs. In addition, profit determinants such as real wages, aggregate demand and real interest rtes have more potential than aggregate profits in explaining profit trends apparently because comparison of firms based on total profits would not bring out the quality of profitability. As properties are given as collaterals for loans availed, fall in their prices result in company failures in the short run. Similarly new companies meet with failures than the long standing ones. Similarly real interest rates instead of nominal interest rates have been found to be responsible for long term corporate failure. This is confirmed by debt-deflation theory (Vieghe,2001) It has been found that a weak corporate sector is responsible for worsening recessionary trends and can even bring about a recession as was proved in East Asia crisis (Hussain and Whilborg,1999). Voluntary liquidations are not necessarily associated with corporate failures. Rather they are resorted to by the wise managers when the liquidation value fetches more than the going-concern value and face value of the outstanding debt (Kim, Schatzberg, 1987). Castagna and Matolcsy(2001), have, in their study of Australian experience on corporate failures, laid down five issues involved in the prediction of corporate failure, namely definition of failure, varied financial reporting standards, alternative accounting measurements, absence of theory on failure and the magnitude of social and financial costs in relation to failure phenomenon. According to this study, a failure is said to occur when there is default in fixed interest payments, default in payment of preferred dividends, default to meet creditors’ dues and when there is a move for liquidation. This study highlights the difficulties in neutralising the financial statements of different companies and of the same company for different periods before the studies are taken up for analysis for what ever purpose. They are bound to be different from country to country also. Hence, before developing financial models for failure, standardisation of computation and assembling the data from the heterogeneous financial statements is required. Ten financial ratios selected by this study to find the discriminating characteristics between the liquidated companies and surviving companies were Return on Shareholders funds, E.B.I.T/Total Assets, Operating Income/Operating Assets, Quick Ratio, Surviving Current Ratio, Gross Cash Flow/Total Debt, Total Debt/Total Assets, Working Capital/Total Assets, Retained Earnings/Total Earnings and Market Capitalisation/Total Debt. For the purpose, the selected 21 listed public limited companies that were liquidated during 1963 to 1977.having minimum data requirements. This study says that modes identified are only useful to identify the even of failure and not the timing of the failure. White (2003) says that bankruptcy is the legal mechanism to remove inefficient firms from the market. Two thirds of 62,000 firms which filed bankruptcy applications in 1984 were for liquidation. Dun and Bradstreet (1986) state that the firms which filed for bankruptcy in 1985 had total liabilities of nearly $ 33 billion. White (2003) says that bankruptcy applications are not necessarily from inefficient firms whose assets if redistributed would be useful for some other economic activities but also from viable firms. And that not all inefficient firms meet with bankruptcy. Firms that fail may choose to liquidate even if their resources are the most valuable. Since the U.S. bankruptcy system allows for inefficient to continue their operations, long-run efficiency of the economy gets delayed by delaying the movement of resources fro more efficient use. A study done by the Department of Justice found in a sample of 500 firms which filed for bankruptcy to liquidate, the ratio of total liabilities to assts was 7.3 % and the ratio of secured liabilities to assets was 1 %. Because of high ratio, unsecured creditors do not receive any share of realisation from the salvaged assts. (Ames et al., 1983) On other hand, in the case of sample 500 firms that filed bankruptcy applications for reorganisation, the average ratio of total liabilities to total assets was 1.4 and the ratio of secured liabilities was 0.60. This shows that firms wanting to reorganise are in a better financial position (White, 2003). Chapter 3 Research methodology Research Methodology is the framework within the confines of which a study is conducted It lays down approach to a problem to be applied in a research programme. This chapter will choose a method by highlighting different research methods in practice. There is no single best method for research. Rather an approach most effective for the solving of the problem under study will be selected. And “Research methodology is always a compromise between options in the light of tacit philosophical assumptions, and choices are frequently influenced by availability of resources” (Gill J, Johnson P 2002) The end result of this study should go a long way in formulation of strategies for liquidation assessment through strategic financial statement analysis for which it has become necessary to apply appropriate research methods. This section includes research design and justification of the methods selected and also narrates how the research has been conducted to achieve the object of this study. 3.1 Data requirement Studies are conducted by either the quantitative or qualitative research approaches. Saunders et al (2003) quotes Carl Gustav Jung as saying that science which relies on the concept of averages is not suitable for subjective studies. This study being subjective, statistical science which works on averages is considered unsuitable for achieving the aim of this study. The present study was found to be feasible only by way of adopting qualitative research methods. The liquidation assessment could be better studied as a hands-on experience rather than as a perspective study as in quantitative approach which calls for validity and reliability and requires a lot of theoretical persuasiveness. To achieve the objectives of this study, many ways (methods) gathering information will be available were available through literature reviews and analysis of financial statement of different liquidated companies in the past. 3.2 Research design and justification In research terminology, the research objectives are theories to be developed. Saunders et al endorse the proposition of Engelen and Zwaan (1994) that theory development trajectory involves using of existing theory and practices and construction of a new theory reflecting reality with a high predictability. Testing of the same is done to determine its confirmation or rejection in other words answering the research questions as correct or not. In theory application, a problem is diagnosed, defined and theories (suggestions) to improve the unwanted situation (deficiency) are determined (arrived at) see figure 3.1 below. (Saunders et al 2003) Figure 3.1 Figure 3.1 The literature review will throw open several aspects of corporate failures, recession and several case studies and sources of research giving rise to new theories of liquidation assessment. Figure 11 confirms this. Saunders et al (2003) state that Engleen and Zwaan differentiate two main research cycles for management studies. They are 1) Empirical cycle with five steps of Research goal, Research design, Data Collection, Data Analysis and Reporting. And 2) Design cycle also has the five steps of Design Goal, Design specifications, generation of different designs, selection from different designs and Reporting. As the author is decisive about only qualitative approach for this study, empirical analysis is considered unnecessary. The statistical analysis even if done can not give any answer to problem addressed or research question since it does not warrant study of causal relationship between variables. 3.2.1 Research philosophy Saunders et al (2003) agree with the suggestion of Remenyi et al (2000) that research philosophy is of three kinds. They are positivistic philosophy, realistic philosophy and interpretivistic philosophy. This study falls largely under the interpretivistic philosophy as analysis of financial statements which involves facts that are real. In his attempt to understand the causes of liquidation, the author will collect following secondary information through foregoing literature review which discusses current situation of recession different strategies of tackling recession why certain industries/companies are able to survive in recession analysis of financial statements definitions and significance of various rations applied in the analysis. 3.2.2. Research strategy The secondary data collected will be subject to the above qualitative assumptions. Secondary information and data are the support bases for this study. In the literature review, a near-exhaustive discovery will be made as to how analysis of financial statements can predict corporate failures though not their timings. What this study aims to achieve is to think out of the box and to arrive at altogether a different and radical or novel approach for analysis of financial statements for assessing liquidation of companies. The secondary data through literature review would only serve as a beacon for seemingly never ending search and not in itself would answer the problems sought to be solved by this study. Therefore the objects of this research are to be achieved by primary research method adopted in our study that is surveys by means of questionnaire. This study being part of academic pursuit without any sponsorship and due to limited time and resources, financial statements of ten failed companies of the current recession will be analysed to pinpoint the causes of their failures. Saunders et al (2003) label the research process as ‘onion’ having five different layers. This research design will follow the onion strategy. See Table 3.1 below. Table 3.1 Author adopts top down development of the research i.e. starting with the outside layer of Research philosophy, and by peeling one layer after another until the fifth layer of defining of data collection methods. Similar approach is also suggested by Remenyi et al. (2000) 3.3 Method of data collection 3.3.1 Secondary data collection Literature Review of this study has covered a variety of information and statistics necessary for the generalisation and complementing the conclusions derived from primary data. 3.3.2 Primary data collection Population and sample Ten companies that went into liquidations in the recent past due to recession will be selected and their balance sheets strategically analysed. It shall be ensured that balance sheets are audited. 3.3.3 METHODS FOR DATA ANALYSIS AND INTERPRETATION A non-linear approach will be adopted as a qualitative analysis, which focuses on understanding and analysis of data as opposed to statistical techniques (Bryman & Cramer, 1990:) A qualitative analysis puts forth the findings not through statistical procedures but through “illumination, understanding, and extrapolation to similar situations” (Preece 1994). 3.3.4. VALIDITY AND RELIABILITY The validity of research depends up on the internal and external validity of the research. Whereas the internal validity is “the extent to which its design and the data that it yields allow the researcher to draw accurate conclusions about cause and effect and other relationship within data” (Leedy & Ormrod, 2001:103), the external validity is “the extent to which its results apply to situations beyond the study itself” (Leedy & Ormrod, 2001:105) 3.3.5 Reliability of the study .This deals with the trustworthiness of the data collected for the qualitative research. Saunders et al (2003) adopts the view of Scale that “the trustworthiness of a research report lies at the heart of issues conventionally discussed as validity and reliability” (Saunders et al 2003) As per the advice the researcher started writing this at the earliest possible opportunity instead of collecting every thing upfront required for the thesis. For example, Wolcott points out that “many qualitative researchers make the mistake of leaving the writing up until the end i.e. until they have got “the story” figured out. However, Wolcott makes the point that ‘writing is thinking’. Writing actually helps a researcher to think straight and to figure out what the story should be. The motto of every qualitative researcher should be to start writing as soon as possible.” (Wolcott) Chapter 4 Discussion and Conclusion This proposal contains brief literature review of the company failures and the nearly 2.5 years old current recession. As proposed last available including the previous four years’ audited financial statements of liquidated companies will be selected and analysed to confirm the reality of their failures. In the process, they will be examined to answer the following aims and objectives of this study in order to answer the research questions stated above. 1) To ascertain why these companies failed in spite of continuous monitoring by the regulatory authorities and 2) To conclude whether the liquidation is preventable or is it a logical process whenever the recession occurs. 3) To arrive at a financial model for liquidation assessment without co-relational studies. Works Cited Adam Abner. Company Liquidation Continues to Soar, 2010. Web.15 March 2010. Alvarez II Tony. Global Taxand Conference. Alvarez and Marsal, Web 15 March 2010. Gamble William. Restructuring in Asia - A Brief Survey of Asian Bankruptcy Law.1998. Web 15 March 2010. Ames, Nancy, et al. An evaluation of the U.S. Trustee Pilot Program for Bankruptcy Administration; Findings and Recommendations. Consultants’ Study for the U.S. Dept. of Jutsice, Cambridge, MA; Abt Associates. 1983. Print. Begbies Traynor Group. Over 140,000 Companies Show Real Signs of Financial Distress in Q4 2009. Web 15 March 2010 Benito, A and Vlieghe, G W. ‘Stylised facts on UK corporate financial health: evidence from micro-data’, Financial Stability Review, 2000:8, Bank of England.Print. Bryman, A. and D. Cramer. Quantitative Data Analysis for Social Scientists. London: Routledge, 1990. Print. Edwards Richard C. ‘Stages in Corporate Stability and the Risks of Corporate Failure” The Journal of Economic History, 1975, 35(2) pp428-457 Engelen van and Zwaan van der .Theory Development and Theory Application. 1994. Print Gill John and Johnson Phil. Research Methods for Managers. Third edition Sage Publications London, 2002, Print Hussain, Q and Wihlborg, C. ‘Corporate insolvency procedures and bank behaviour: a study of selected Asian economies’, IMF Working Paper No. WP/99/135. 1999. Print. Jacobs Stevenson. Letter: Lehman accounting tricks possibly illegal, 2010. Web 19 March 2010 Kim E Han, Schatzberg John D,1987, Voluntary Corporate liquidations, Working Paper # 523, University of Michigan Leedy, P.D. and Ormrod, J.E. 2001. Practical Research: Planning and Design. NewJersey: Meryl Prentice Hall, 2001. Print. Perry Mark J. Darwinian Effect of Recessions: Weak Companies Fail, Leaving The Survivors Bigger and Stronger.2008. Web.15 March 2010 Preece, J. Human-computer interaction. Addison Wesley. 1994, Print Professional broking, 2010, Broking.co.uk Web.15 March 2010 Reinhart Carmen and Rogoff Kenneth S. The Aftermath of Financial Crises, Paper to be presented at the American Economic Association meetings in San Francisco, Saturday, January 3, 2009 at 10:15 am. Session title: “International Aspects of Financial Market Imperfections”.2008. Web 20 March 2010 Remenyi, D., Money, A., Sherwood-Smith, M., and Irani, Z. The Effective Measurement and Management of IT Costs and Benefits (2nd ed.), Butterworth Heinemann, London, 2000. Print. Rolling Stone, 2009, Circuit City Falls Victim to Recession, Begins Liquidation, 20 March 2010 Saunders, M., Lewis, P. and Thornhill, A. Research Methods for Business Students. Prentice Hall. 2003. Print. Vlieghe Gertjan, 2001, Indicators of fragility in the U K corporate sector, Working Paper Series, White Michelle J, 1989, The Corporate Bankruptcy Decision, The Journal of Economic Perspectives, Vol. 3 (2), 129-151 Wolcott, H.F. Writing Up Qualitative Research. Sage Publications, Newbury Park, California. 1990. Print. . . Read More