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Companies Going through Bankruptcy Essay

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Updated: Apr 4th, 2022

At a time when the global economy is in a crisis, many companies are facing challenges in their efforts to maintain the often-desired profit margins while generating enough cash and liquidity for daily operations (Wu, 2004).To be sure, today’s economy has made a number of companies make decisions, such as filing for bankruptcy, to enhance their survival (Charitou & Trigeoris, 2007). Oftentimes, however, it does not always mean that a company that files for bankruptcy is closing its business operations. Instead, it may imply that the organization is restructuring so that it becomes more efficient, market-driven as well as productive (Wu, 2004).

Recent research findings reveal that most companies that have been declared bankrupt or are in the process of doing so have had limited opportunities to obtain liquidity for many different reasons. Increasingly, banks that offer short-term financing are balancing issues of reduced capital structure and condensed levels of risks that they are willing to take (Huang, 2003). This reality is particularly challenging for companies with global operations and for organizations that may have their cash balances fragmented across different geographical locations and bank accounts (Charitou & Trigeoris, 2007). This paper scrutinizes the phenomenon of a company’s bankruptcy as an emergent and recurrent finance-operation issue. In this regard, the paper presents a viable analysis of the present-day bankruptcy variants in companies based upon a number of accounting and managerial strategies. The paper employs the use of both financial and non-financial (operational) strategies and models as the basis upon which bankruptcy occurs and should be predicted.

Operational Performance Measurements and Bankruptcy

According to Shumway (2001), the current bankruptcy models tend to focus more on financial data than other managerial indicators. Progressively, however, bankruptcy prediction efforts are being tailored upon both the operational performances and financial measurements of companies (Huang, 2003). While previous research focused more on financial statements, the role played by factors that are measured on the basis of non-financial factors, in determining a company’s future performance and the probability of it filing for bankruptcy, cannot be overturned (Shumway (2001).

In many ways, the often ignored variables have become relevant in measuring the operational risks and bankruptcy potentials of companies. Because of this, various models that focus on both financial and non-financial factors have been developed to determine how and when a company is likely to become bankrupt. In one study, Leach and Newson (2007) report that the probability of a company’s growth, when evaluated on the basis of customers’ needs and market penetration indicators, becomes a major factor in its financial successes or bankruptcy in the long run. In other words, the variations in a company’s market and financial potential are the functions of higher leverage and growth patterns (Shumway, 2001). Moreover, customer performance measures are among the major variants of financial success or failure. A company that reduces its workforce is often associated with ‘‘condensed’’ assets and high debt that lead to bankruptcy (Leach and Newson, 2007).

The Relationship between Capital Investment, Cost Planning, and a Company’s Bankruptcy: A Focus on Liquidity

Various research findings show that there is a close relationship between a company’s vulnerability to bankruptcy and its capital investments based on liquidity (Huang, 2003). In many different ways, liquidity describes the ease with which an item can be sold immediately or long after its purchase without incurring extra costs or lowering its price (Ratner & Stein, 2009). Whenever a company considers any potential investment in an asset, it should as well consider the ability to sell it in the future (Huang, 2003). Viewed this way, the organization should consider the cost to be incurred in selling the item in the future as well as the price at which it will be sold (Ratner & Stein, 2009). Indeed, these considerations stem from the notion that the liquidity of assets matters in determining a company’s financial prospects and position.

In context, the various issues considered may negatively affect the future cash flows of a company’s assets and make it file for bankruptcy (Cokins & Blocher, 2013). Since future cash flows are directly affected by liquidity, it is an important factor in pricing assets. Put baldly, liquidity affects the pricing of different classes of assets (Charitou & Trigeoris, 2007). No wonder, Huang (2003) views the cost of illiquidity as equal to the cost of a buyer’s remorse and a precedent to bankruptcy or otherwise these days.

Seemingly, then, what matters the most, in the decision-making processes leading to filing for bankruptcy, is the kind of an asset that a company buys (Ratner & Stein, 2009). For example, an organization that buys stocks in large companies that are publicly traded, especially on well-established stock exchange markets such as the New York Stock Exchange (NYSE), considers whether or not it will be in a position to sell it again with almost no costs involved (Huang, 2003). Increasingly, for most such companies, the chance of filing for bankruptcy is minimized. However, the relationship between bid-risks and the growing number of companies seeking bankruptcy positions cannot be overstated (Leach & Newson, 2007). Many sources of illiquidity, leading to bankruptcy, become the drivers of the bid-ask spread. In other words, if the stock is more illiquid, the importance of its different sources of illiquidity is adjusted. In such a case, the occurrence of a bid-ask spread becomes likely. Nowadays, the bid-ask spread covers many aspects of liquidity because it is driven by the most important determinants of illiquidity and bankruptcy decisions.

The bid-ask spread is the ‘‘nature’’ existing between the price that a stock can be sold for (the bid price) and the costs of purchasing it through a market maker. For most companies going through bankruptcy processes, the first tests repeatedly reveal the pricing of liquidity risk. In cases where the relative bid-ask spread is the proxy for the liquidity, then there are no signs of a risk premium for the threat itself (Ratner & Stein, 2009). In fact, in many such cases, the turnover rate proxy may provide evidence of a slightly significant liquidity risk premium in the returns of the 3×3 turnover rate and beta portfolios (Leach and Newson, 2007). However, this analysis is not all-inclusive and representative of the weighting convention, portfolio formation, or the presence of the Fama-French factors. Nevertheless, the culminating factors are leading pointers to the widespread rate of bankruptcy of various companies in many different countries (Huang, 2003).

Cost Volume Profit Analysis and Bankruptcy

Cost-volume-profit (CVP) analysis is anchored on the understanding that for companies to evaluate and sketch out their operations effectively, they should estimate their revenues and expenses (Shumway, 2001). In this regard, an organization that uses CVP analysis to determine the activities required to avoid a loss often achieves its intended profit outcomes just as it becomes able to evaluate its organizational performance well in advance to avoid insolvency (Cokins & Blocher, 2013). CVP analysis is attached to the basic profit equation, (Profit = Total Revenue – Total Costs). Companies that observe it are unlikely to be bankrupt mainly because they are able to avoid risks (Shumway, 2001). In fact, CVP analysis is a risk instrument that minimizes the chances of a company becoming bankrupt even in today’s competitive economy. In a fairly controversial study that focuses on the United States’ bankrupt and non-bankrupt organizations, Leach and Newson (2007) report that companies that are in deep financial troubles tend to apply no CVP-based practices as risks management instruments. In fact, most firms that file for bankruptcy do not manage their foreign currency risks using CVP analysis (Wu, 2004).

The Relationship between Bankruptcy and Business Analysis/Valuation

There is considerable research evidence that business valuations are important variables in measuring a company’s likely financial outcomes in spite of its ability to restructure its operations before and after bankruptcy (Ratner & Stein, 2009). Business valuations need to be carried out for many reasons. In the past three decades, stakeholders investing inequities of a financially challenged organization have always demanded reports on their valuations. This is usually done to find out the effects that their investments could do in yielding anticipated outcomes (Wu, 2004). Perhaps, the explanation resides in the notion that lenders often arrive at their decisions in relation to a company’s value versus its outstanding debt ratio (Charitou & Trigeoris, 2007). In addition, individuals who take over the ownership of a company before it is declared bankrupt require valuation reports to assist them in liquidity-based decision-making processes (Ratner & Stein, 2009).

Conceivably, the greatest valuation indicator, in relation to bankruptcy, is the distribution marketing models used by a company. In providing information relating to where a company stands, this model is best applied through market research aimed at identifying future needs of customers as contextualized by a company’s new shareholders (Wu, 2004). In retrospect, the distribution channels ought to be aligned to customers’ patterns of purchase or service-seeking trends in a company’s regions of operations. In the end, the valuation for local distribution channels is planned differently compared to the international channels based on the probability of financial success. At times, however, the scope of the distribution in valuation is limited to a single intermediary (Ratner & Stein, 2009).

In the long run, business valuation processes and results are not just financial predictors of the risks of bankruptcy but are important indicators in a business’ life cycle as well (Wu, 2004). Seen this way, business valuations for financially incapacitated organizations or those filing for bankruptcy provide special ‘‘contexts’’ for the determination of value depending on the nature of the company carrying it out (Ratner & Stein, 2009).

Conclusion

Recent researchers have recognized that bankruptcy is becoming a common occurrence for many businesses. However, while financial factors and ratios remain important in predicting bankruptcy, operational and non-financial factors have a significant bearing on it. Both financial and non-financial factors have proven to be useful variables for forecasting and explaining bankruptcy. To the degree that company managers and other stakeholders tumble in their deliberations on important indicators, the major factors that inform bankruptcy and its prevention measures are well elaborated in this paper.

References

Charitou, A., & Trigeoris, L (2007). Managerial discretion in distressed firms. British Accounting Review, 9 (4), 323-346.

Cokins, G., & Blocher, E (2013). Cost management: A strategic emphasis. New York: McGraw-Hill Education.

Huang, M. (2003). Liquidity shocks and equilibrium liquidity premier. Journal of Economic Theory, 109 (2), 104-129.

Leach, R., & Newson, P. (2007). Do firms manage their earnings prior to filing for bankruptcy? Academy of Accounting and Financial Studies Journal, 23 (2), 198-200.

Ratner, I., & Stein, G. (2009). Business valuation and bankruptcy. Hoboken, New Jersey: Wiley and Sons.

Shumway, T. (2001). Forecasting bankruptcy more accurately: A simple hazard model. Journal of Business, 74 (1), 101-124.

Wu, Y. (2004). Using non-financial information to predict bankruptcy: A study of public companies in Taiwan. International Journal of Management, 21(2), 194-20.

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