Should anyone have seen it coming?

Transcription

1 Prediction and Prevention Tim Douglas, CMA, MBA Senior Lecturer, Saudi Industrial Development Fund Should anyone have seen it coming? In the three years prior to its bankruptcy in 2008, the largest to date in U.S. history, Lehman Brothers reported steadily increasing and robust net income figures of: $3.3 billion in 2005 $4.0 billion in 2006, and $4.2 billion in 2007 Cash flow from operations, however, which should have provided at least a hint of the financial disaster to come, was negative in those three years: $12.2 billion in 2005 $36.4 billion in 2006, and a whopping $45.6 billion in 2007 What was everyone looking at? 1

2 Who or what is to blame? The list is long.. Senior management Ineffective Boards & Audit Committees External Auditors Regulators (Stock Exchanges & Central Banks) Rating Agencies & Analysts Politicians Vast increase in proprietary trading by banks (their own money at risk) Remuneration packages focused on short term success significantly increases risk taking No penalty for failure And, above all, GREED Stewart Hamilton, Professor of Accounting and Finance, and Dean, Finance and Administration, IMD teaches on the High Performance Boards (HPB), Strategic Finance (SF), and Orchestrating Winning Performance (OWP) programs. Causes of Corporate Failure Corporate Collapse McRobert and Hoffman 1% Sheer bad luck 15% Internal problems triggered by external factors 52% Internally generated problems within management s control Eight Critical Defects Corporate Collapse McRobert and Hoffman One-man rule A non-participating or ineffective board An unbalanced senior management team A combined chairperson/chief executive Inadequate strategic understanding of the industry A weak finance function Lack of management depth A chief executive who believes he/she can achieve fantastic success in any business or sector 2

3 The Trajectory of Failure The Dangerous Dozen Corporate Collapse McRobert and Hoffman Companies that: 1. display certain defects in management structure (usually associated with one man rule) show two errors of omission and three of commission. The Trajectory of Failure The Dangerous Dozen Corporate Collapse McRobert and Hoffman The two errors of omission are: 2. the neglect of accountancy information systems and, worse, 3. the failure to respond adequately to long term changes in their environment. The Trajectory of Failure The Dangerous Dozen Corporate Collapse McRobert and Hoffman The three errors of commission are: 4. a tendency to overtrade or 5. to launch a big project which is beyond the company's resources, or 6. to allow their gearing to increase so that even normal business hazards are a constant threat. 3

4 The Trajectory of Failure The Dangerous Dozen Corporate Collapse McRobert and Hoffman The process of decline is accelerated as 7. cash flow deteriorates rapidly. Some companies at this stage, even though competently managed, can be severely damaged by 8. constraints that are placed upon their ability to respond to change. The Trajectory of Failure The Dangerous Dozen Corporate Collapse McRobert and Hoffman Then, as a company slides down the path to insolvency 9. its financial ratios deteriorate, it begins to 10. employ creative accounting. At the same time, 11. certain non financial symptoms start to appear and 12. the company begins to enter its dramatic last few months. So what do we do when we sense impending doom? Damage assessment: Factual evidence of just how badly the company is under performing? Underlying causes: The search for clues. How did we get here? Environmental scanning: Spotting threats and opportunities that may complicate or facilitate the turnaround process. 4

5 So what do we do when we sense impending doom? Taking stock: What resources do we have to work with and what critical resources are missing? Assimilation: The process of ingesting and digesting large amounts of data and information. Strategy Formulation: "What if?" Modeling. Target Selection. Charting the course. Navigation : Milestone accomplishments and course correction Damage assessment: Factual evidence of just how badly the company is under performing? Altman s Z Score Model A Quantitative Approach that uses accounting variables Altman s Z Score Original Z score component definitions and weighting factors for publicly traded firms Z = 1.2T T T T T 5 T 1 = Working Capital / Total Assets T 2 = Retained Earnings / Total Assets T 3 = EBIT / Total Assets T 4 = Market Value of Equity / Total Liabilities T 5 = Sales/ Total Assets 5

6 Altman s Z Score Zones of Discrimination Z > 2.99 Safe Zones 1.81 < Z < 2.99 Grey Zones Z < 1.81 Distress Zones Altman s Z Score Private Mfg. Company The original Z Score (1968), initially designed for publicly traded companies, was revised in 1995 to accommodate private manufacturing companies. Model A of the Z Score was a complete re estimation of the model to provide for the impact of substituting the book value of equity for the market value. Altman s Z Score Model A Z score for private manufacturing firms Z' = 0.717T T T T T 5 T 1 = Working Capital / Total Assets T 2 = Retained Earnings / Total Assets T 3 = EBIT / Total Assets T 4 = Book Value of Equity / Total Liabilities T 5 = Sales/ Total 6

7 Altman s Z Score Zones of Discrimination Z' > 2.9 Safe Zone 1.23 < Z' < 2. 9 Grey Zone Z' < 1.23 Distress Zone Paradigm Shift The passive use of predictive models overlooks the possibility of using them actively. With the help of a paradigm shift, the active use of a predictive model allows the role of the observer to shift to that of a participant. Active Use of Predictive Models A manager may use a predictive model that relates to business affairs of a company by deliberately attempting to influence the model s measurements. The manager, acting as a participant rather than an observer makes decisions suggested by the parameters of the model to control the prediction of the model. 7

8 What if? Modeling Year Year Year Year Ratio Analysis Actual Actual Actual What If? Z-Factor Variables Working Capital 100,000 90,000 80, ,000 Total Assets 400, , , ,000 Retained Earnings 75,000 95,000 90, ,000 EBIT 65,000 80,000 70,000 95,000 Shareholder's Equity 180, , , ,000 Total Liabilities 220, , , ,000 Sales 457, , , ,000 Altman's Z-Score ( Private Manufacturing) Working Capital / Total Assets Retained Earnings / Total assets EBIT / Total Assets Shareholder's Equity / Total Liabilities Sales / Total Assets Altman Z-score Underlying causes: The search for clues. How did we get here? Argenti s A Score Model Qualitative models rest on the premise that the use of financial measures as sole indicators of organizational performance is limited. For this reason, qualitative models are based on nonaccounting variables. One of the most notable of these is the A score model attributed to John Argenti (1976) which suggests that the failure process follows a predictable sequence: Defects Mistakes made Symptoms of failure 8

9 Environmental scanning: Spotting threats and opportunities that may complicate or facilitate the turnaround process. Taking stock: What resources do we have to work with and what critical resources are missing? Assimilation: The process of ingesting and digesting large amounts of data and information. N.B. It is in the interpretation of this information that the real art of leadership lies. 9

10 Strategy Formulation: "What if?" Modeling. Target Selection. Charting the course. Facilitation Mechanism Interactive What if Models.this process of data gathering, hypothesis testing, reflection, strategic learning, and adaptation is fundamental to the successful implementation of business strategy Robert M. Grant

11 Can you prevent business failure? Yes, as long as you act early enough! Thank You 11