Lessons From Corporate Collapses

I suppose by now you are aware that Wall Street is experiencing difficult times with more large, well known companies undergoing extreme financial stress and some looking like they will go into liquidation.

I do not want to focus on any one specific company nor will I examine or speculate as to the reason one company failed whilst another has, but I would like to share with you some thoughts about what we can take out of these collapses and how you can apply general concepts to your business and keep it afloat.

Background to current events

All the trouble on Wall Street goes back to an innovative product that allowed illiquid assets to be turned into a liquid asset, Collaterised Debt Obligations (CDOs). CDOs allowed any number of debts to be packaged up into bonds and sold to investors for cash today based on the expected future cash flows that the underlying debt held. The idea was fantastic and applied to a wide range of future cash flows including music concerts, credit card debts, utility bills and of course residential mortgages which had their own designation Residential Backed Mortgage Obligations (RBMO). The debts were packaged up and given a Rating from AAA all the way down to CCC. The rating indicated how likely it was to default, AAA the least likely and CCC likely to default.

Where it all went wrong was when the rating agencies failed to classify the risk of RBMOs properly, loans made to low income persons or unemployed people were given the same ratings as loans made to well to do employed persons. The theory behind it went along the lines of people will do anything to keep their home and traditionally there is a low rate of defaults on mortgages.

Lesson begins here
Where did the banks, brokers and insurance companies get it so wrong they face dissapearing leaving a trail of mess behind them? The are several aspects to the answer:

1. Improper risk management & Improper diversification
2. Failure to understand their products
3. Failure to understand their counterparties
   

There are other aspects but I would like to focus on the ones listed above as these lessons can be applied to any company of any size.

1. Improper risk management & Improper diversification
To understand risk management you first must define risk, risk is uncertainty and it is uncertainty in business that creates volatility in earnings and profits. It is good to take on some risk as this can lead to gains but you do not want so much of it that it can wipe you out. The job of risk management is assign the correct level of risk to your company so there is some upside risk but not a level that could wipe you out.

The level of collateralised debt obligations (CDOs) purchased were extremely high and disproportionate to other assets held. Though many of the CDOs held were of given a rating of investment grade (BBB) they were not actually as safe as they seemed. CDOs were not like other debt that was issued and could have been held. Risk management should have required proper diversification not only amongst credit ratings but the types of assets.

You are probably asking how does this apply to me and my business. The answer is every time you add a new line or enter into a new venture think about the risk you are taking on. Ask yourself does the venture offer more upside return than downside? Does entering into this new venture or taking on this new product have the potential to destroy my business if it fails? What and how much do I have to gain from this venture?

If you have answered that there is significant risk or it there is little upside but a great deal of risk it may be worth passing on. In the event that there is quite a lot of downside that could wipe out your business but the upside potential is so great your job is then to design a plan to isolate the risk and have a risk management plan on paper. Isolating the risk may involve legal structures, guarantees, binding agreement with the counterparty or implementing the deal in away that differs from how it was originally envisioned.
Make sure you control the risk, don't let it control you.

2. Failure to understand their products
A great deal of heart ache at present has been caused by the lack of understanding brokers, traders, asset managers and other players in the financial markets was caused by failure to understand the products they were dealing with. You may be saying to yourself in hindsight how could it be hard to understand simple loans resold to others. Unfortunately the way the loans were packaged is far more complex than how I described them above. The loans were packaged in a complex manner each had differing legal obligations associated with them.
All of this complexity gave rise to products that many intelligent people could not understand, did not take the time to understand or even convinced themselves that they understood the product. Once the ball started rolling and profits started to appear people stuck with what seemed to be working.
How does this apply to your business? Quite simply if there is a product or service you can add to your business but you don't understand it do not add it. If you are happy with your current business offering, think about why you want to change it and what it will add to your business. Your business in an investment you need to understand it and every part of your offering. Fads come and go maintaining your core business is more important than adding on aspects to your business you don't understand. Everyone else might be admiring the emperors new clothes but you don't have to be one. If it doesn't sound right to you let the opportunity pass and take up the next one you do.

3. Failure to understand their counterparties
Each bond had a counterparty, that is the person who issued it and owed the money to the bond holder. A large problem with CDOs was that it was not clear who the counterparty was. The complex packaging meant all to often you had to trace back through several parties to find out who actually held the asset that was going to produce the cash flows.
In your business know who you are dealing with; this will give you two clear advantages. Firstly you are able to tailor your offering to your client and adapt to changes as they require it. Second are able to access information about your counterparty. Information about your counterparty has far to many advantages to list but quite obviously you know who to contact to expand your offerings, who to issue legal proceedings against if you are required to do so and lastly you can atcually communicate with them without needing to go through intermediaries or volumes of legal documents.

As events unfold in the coming weeks and months more will be revealed and there will be more lessons to learn from these corporate failures. I look forward to sharing with you some thoughts to take away from this downturn and how you can improve your business during these turbulent times.

Company Health Check

You may have noticed there has been a general slow down in your businesses sales due to weakening in the economy and consumer confidence. This slow down may now be impacting your bottom line. Rather than ignore the impact it is having on your business take it as a timely reminder to take a better look at your accounts and check the impact it is currently having on your business and extrapolate the trend to see how it will look three, six, nine and twelve months from now.
Take a close look at your sales, inventory, gross margins, accounts receivable and payables.

Sales
Sales will tell you the story about how much your business is growing or slowing. Quantifying the change in sales will begin tell you where your business is going.

Inventory
Check the inventory and assess the ageing, if it is now moving significantly slower you may need to look at ways of decreasing your stock and reducing inventory purchases. Even if it has not slowed a great deal it is a good idea look at ways of improving your inventory turnover. Money tied up in inventory is cash that can be better deployed elsewhere in the business or earning you interest.

Gross Margins
Gross margins are going to tell you if you are making money and if you have cash for your expenses. If you are able to break this down by product line you will have a level of control and power to improve your business and keep it profitable. You may be expending a great deal of effort selling lines that are not bringing in the margins your require whilst another product you have been neglecting has fantastic margins that are worthy of your attention.

Accounts Receivable
The important thing to look at in your accounts receivable account is the balance and the ageing. As the economy slows accounts receivables collections slow too. Keeping check of outstanding debtors is extremely important especially where a single debtor constitutes a material amount of your business. If you are dependent on several key clients watch for changes in payment, if possible try diversify your client base. I have seen well run businesses with a good product fail when one client could no longer pay their debts, don't let this happen to your business.

If you are not having success in collecting a debt from a client and you are getting worried about collection consider either contacting your solicitor and issuing the debtor with a statutory demand (stat demand) or passing the debt to debt collector on a success fee basis. A stat demand can be issued where the value exceeds a set level which will vary depending in which country you reside. The stat demand requires the debtor to pay the debt, in the event they fail to pay they will come before the court and may be made bankrupt or put into liquidation.

Accounts Payable
Your accounts payable account will tell you a great deal about the health of your company even if you already have a feeling you are needing to stretch supplier terms. Prepare a creditor aging schedule and take a look at how long it is actually taking you to pay your creditors it may suprise you to see it quantified in terms of how many days creditors have been outstanding. If you notice you are having difficulty paying your debts and are having to stretch supplier terms it may be worth seeking professional assitance to improve your working capital.
If you revieve a stat demand DO NOT IGNORE IT speak to your solictor or accountant straight away. If you do not respond and take action to the stat demand a winding up appllication may be lodged and your company liquidated.
It is vital that you keep up to date with your statutory payments such as taxes and work place insurances. Failure to pay these may result in these organisations lodging and application to wind up your company as you are presumed to be insolvent. Keep up to date with them and seek external advice from a professional accountant if you are falling behind and unable to pay them. I have seen many companies fail as they assume they can pay other creditors ahead of the tax man with no repercussions; they were wrong.

Project your accounts
If you don't prepare budgets you should start. Budgeting will help you keep track of where you have been and how you are comparing to your projections. Most importantly preparing budgets will show you where are heading and should flag up times where you may experience difficulty paying debtors or collecting receivables.
If your budgets are showing you are going to experience trouble in a month or twos time take action now, do not wait for the date to come or fudge your projections to "make the numbers work". Create a plan of action, commit it to paper and put it into action as soon as you can. Inaction, failure to plan and address forthcoming challenges have taken down many companies.

I hope this has given you some ideas of what to look at in your company and inspired you to take action sooner rather than later. If things are looking like they are heading south and you can't see a way of improving your situation see a professional sooner rather than later. The small cost of seeing one today will be significantly less than letting the situation get worse or losing your livelihood through inaction.