A firm is technically bankrupt if its cumulative losses exceeds its common stock investment. More specifically, bankruptcy occurs when the sum of the retained earnings and the common stock is a negative number. Stated differently, the management has used up all of the equity of the firm when the negative value of the retained earnings exceeds the value of the common stock.
Why Bankruptcy Occurs
The primary cause of bankruptcy is having the unreasonable expectation that the industry is locked into the growth phase of the product life cycle. The executive team reasons that it can count on increasing revenue to pay for substantial investments in inventory and R&D.
This expectation emerges as a result of market growth in the early quarters. The underlying assumption is that the market growth is driven by forces outside the company and will continue growing without interruption. This is a faulty assumption. The truth is that the market is driven by the collective decisions of the industry's participants.
There is no growth curve built into Marketplace. If demand is growing, it is because the firms are introducing new products, expanding into new markets, hiring new sales people, developing better advertising campaigns, lowering prices, and adding promotional displays. If a firm's demand is increasing relative to others, it means that, for now, it is doing a better job than the competition.
Executive teams are often shocked when demand drops off sharply. Sudden loss of demand may be caused by many factors, including:
- A curtailing of marketing efforts across the entire industry (usually due to a lack of supply).
- The entrance of a new competitor in the firm's market.
- A major market push by a competitor (usually accompanied by new brand designs, lower prices, and/or better advertising).
- A miscalculation of the effectiveness of one's own marketing decisions (brands are weaker than hoped, and/or ads are poorly rated).
The fundamental problem is that the executive team bets that their demand will grow and budgets large expenditures in anticipation of this growth.
A second cause of bankruptcy is when an executive team fails to realize that R&D expenditures are treated as an expense rather than an asset. R&D expenditures of two, three, and four million are reflected on the bottom line, causing large losses that are accumulated in retained earnings. If profits from continuing operations do not offset the expenses, the negative retained earnings figure can quickly exceed the common stock figure. As a rule of thumb, the firm should not spend more in R&D than it receives in venture capital as a result of the business plan.
A surprising (for some) side effect of declining retained earnings is a loss of borrowing power. The clever executive team that invested early in R&D may find itself without the debt capacity it anticipated. It therefore becomes technology rich and cash poor, and is unable to produce sufficient quantities of the brands containing the new technology.
How to Avoid Bankruptcy
There is no reason for a team to roll the dice on the future. Demand is entirely logical. The executives must ask themselves what they have done using the market simulation to ensure that their demand figures are reasonable. Have they increased their advertising at a faster rate than their competitors?
Do they have new sales offices, more sales people, or lower prices? Are there other forces at work which could cause demand to soften, such as mass reduction of marketing by the rest of the industry due to inventory shortages or a new competitor?
A simple and conservative test is to compare your projected gross margin to the firm's projected expenses. First, multiply last quarter's demand per sales person by the number of sales people scheduled for the current quarter by the average selling price of all brands carried.
Second, multiply the projected number of units sold by the historical production cost. This will give you an estimate of the cost of goods sold. Third, subtract the cost of goods sold estimate from the revenue estimate to give you the gross margin estimate.
Finally ask: Is the gross margin a number larger that the negative cash position at the end of decision-making? Is the gross margin sufficient to cover most, if not all, costs so that retained earnings do not decline prematurely? If the answer is no in either case, then your expenditures should be curtailed.
How to Get Out of Bankruptcy
Bankruptcy is a clear signal that the executive team has not managed its financial resources wisely. It has essentially failed the market's test. However, the team cannot walk away from the business.
Like Chrysler, it must figure out how to get itself out of this mess. In this way, it can redeem its reputation in the financial community.
A bankrupt firm will find that it has no additional borrowing capacity. Debt is not an option. The executive team must curtail all unnecessary expenditures and stimulate profit building demand.
The only way a firm can pull itself out of bankruptcy is by focusing its energies and resources on its best opportunities. The firm must adopt the earlier recommendation of focus, excel, and expand with success.
To initiate the refocusing effort, the executive team must decide which single segment represents its best option in the market. All marketing activities must be focused on this one segment, and all other market development activities must be placed on the back burner.
The same is true for production. The only brands to be produced must be targeted at the chosen segment. Production of all other brands must be stopped or slowed to a minimum.
Curtailing marketing efforts will only exacerbate the problem. It is easy to be caught in a downward spiral of cutting sales expenses, reducing demand, which requires further cuts in selling expenses. The best approach is to stimulate demand.
Advertising must be reworked in light of the above constraints. New ads must be created. Advertising and sales force should be pumped up to move the inventory and put cash into the checking account. Reducing prices is not wise since it will only reduce margins, and probably retained earnings. With the possible exception of a poorly-rated brand, non-price techniques must be employed to create demand. In all cases, the anticipated revenue must be sufficient to pay for all expenses.
The above recommendations will not result in an instant return to good financial health, but, if done wisely, could result in a return to profitability in two or three quarters. Only after the firm is solidly in the black should it resume its market expansion activities.