A Forecast model of SME failure in UK organization
As the title of my dissertation shows, the main objective of this topic is to know the reasons of corporate failures and thus build up a trustworthy failure forecast or prediction model for use in UK construction industry. This study is fixed on companies which fit into UK standard classification (SIC) General construction and civil engineering from 2002 to 2007. The model is based on small and medium businesses' in the background of EU and UK Companies Act 2006.
Secondly the subject of the dissertation was chosen in a field in which author has an interest, this being under the heading of small to medium sized enterprises in the UK construction industry.
Thirdly the other reason for selecting SMEs under the heading of the construction industry is that in past a majority of the experimental research studies have been done on big public companies for instance Beaver (1965).
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Fourthly the DTI (1999) stated that the input of SMEs in the UK economy is highly important and it is growing fast. It is documented that SMEs make up over 98% of the total business population and 2% of businesses are considered as large or quoted companies.Reasons of choosing the exact area are due to the following evidences.
- The greater part of earlier studies on corporate failure prediction models based on large quoted firms and little work has been done on small and medium enterprises.
- The researcher has a specific concern and knowledge of the selected area.
For numerical method SPSS is used to examine the data and to calculate the financial ratios.
Secondly the reason for selecting this topic is that the nature of topic is so related and challenging in today's time and age and there is also a possibility for more work to be done on this topic.
There are some general reasons as well why SMEs have been ignored for example slowing economy, increase cost of borrowing in a weakening business environment, availability of data and lack of resources Brought (1970); Hall and Young (1991) mentioned in their research work that a primary cause of business failure is shortage of capital, resources and management knowledge.
THE RESEARCH PROBLEM
More than the last three decades an important amount of work has been done in the field of predicting corporate failures Piesse and Wood (1992) and Taffler (1984). Many researchers have developed models by using financial ratios to differentiate between failures and non failure companies. Taffler (1982) and Casey and Bartczak (1985).
The most important and determining piece of work done in the field is by Beaver, 1966; Altman, 1968; Taffler, 1982. However Altman (1968) concluded in his paper that a weakness of the study is that his work is centre of attention on listed organizations where availability of financial data is not a problem. An area of further research would be small firms or unincorporated entities where the frequency of business failures is greater than in large corporations Altman (1968).
The dissertation is based on small firms and also attempts to establish the worth of ratios analysis, especially MDA in predicting private limited company failure in the UK construction sector during the period 2002-2007.
The dissertation also attempts to recognize what are the problems and causes of corporate disaster which are in particular related to small to medium enterprises. It is argued that large firms have different financial profiles than smaller firms (Rees, 1995). It is also interesting to note that during 1980s in UK certain small industrial businesses in miserable areas, experienced failure rates as high as 50 % over a five-year period (Rees, 1995). Ultimately the financial ratios, qualitative and quantitative variables are different as well.
The dissertation is trying to resolve these problems and trying to focus on the area which has been neglected in the past due to the reasons like availability of information for small companies.
Taffler (1982) mentioned that researchers focused more on large unquoted businesses so there is a possibility for more research work in this field and to justify that Morris (1998) mentioned in one of his studies that the financial data for listed companies is easy to get to as compared to small to medium enterprises and that is one of the reason for more research material available on listed organisations as compared to unquoted and small or medium organisations
Research Question.A Forecast model of SME failure in UK organization
Further clarification of research question and sub question
Always on Time
Marked to Standard
As it's clear that my research will be more focus on two parts. The first part is forecasting corporate failures and second is the reasons of corporate failures. Questions relates to forecasting corporate failures.
How we can forecast business failures with such accuracy.
If we can what are the variables or models needs to be considered.
Is it macroeconomic factors/variables or financial indicators?
Research work will focus on following macro economic factors/ variables.
- Economic Instability.
- Financial Ratios
- Inflation, Retail price Index, Interest rate, Credit availability is the major factors to consider the prediction of corporate collapse.
Next section relates to reasons of corporate failures is more focusing on internal structure of management with non financial indicators of business.
The question relates to non financial indicators is that is it improper competences of management, uncompetitive market position, poor planning and decision making, apparent deficiencies' in management or is it a creative accounting or greed management which is the result of corporate failure?
LIMITATIONS OF THE RESEARCH:
The majority of SMEs in the construction industry are recorded as only traders or partnerships and therefore are not required to register their accounts in Companies House (Companies Act 2006). However the sample is faulty in the sense that it comprises only private corporations that are required to register financial information on annual basis in accordance with The Companies Act 1985.
- The variables used were limited to traditional ratios. The reason for that is that cash flow data was ignored due to instability. Taffler (1974) in his original model ignored all the cash flow data and trend data. The justification he provided that, it contributes little to the original model.
- According to Companies Act 1985 SMEs are allowed to file abbreviated accounts for that reason there is a possibility that limited information is available.
- The statistical technique used is Multiple Discriminate Analysis (MDA. The reason for selecting MDA is that as compared to other techniques it is the most relevant and essential technique to develop and test the Z-score model Altman (1968).
- The comprehensive study of other models falls out of range of the dissertation research and most of the research work in UK is focused on
MDA and the best-known are Taffler (1982, 1983) and Morris, (1997).However there is a criticism on the accuracy of MDA and researchers condemn that MDA models are based on certain assumptions that are over and over again violated in the background of failure prediction (Aly et al., 1992).
The probability that a business will remain a going concern is critical to all stakeholders in business but recent global financial crisis and corporate crisis especially in the last decade has turned the world's attention towards corporate failures and what are the reasons and motives behind these corporate failures. However some of these corporate failures are considered as the biggest crisis of this century especially Enron, Arthur Anderson, Northern Rock, Lehman brothers and Barings Bank. Indeed, in the growth phase of the 1980s continuing through 1990s, business failure and bankruptcy has accelerated.
According to the recent figures published by UK's Ministry of Justice that almost 12,000 companies filed for bankruptcy in 2007 in England and Wales. It is predicted that this figure will be increase and around 13,500 companies will file bankruptcy in 2009. (Financial Times, 2 January 2008)
Uncomfortable by these aspects the accounting bodies and organisations have laid special importance on these issues and keep introducing specific methods to manage and decrease the possibility of these setbacks. More and more these bodies are becoming increasingly informed and practical, on the other hand corporate failures are increasing with more force and brutality of losses.
The research work focuses on whether failure can be predicted well before time by developing z- score model using Multiple Discriminate Analysis (MDA). The study has also attempted to introduce refinements to the variables used in developing a Z-score model and also refinements to the definition of failure.
It evaluates the practical application of the Z-score model on companies' profiles in order to analyse the financial situation and the possibility of the failure. In UK and USA incredible research has been done in the field of forecasting distress by using the Z-score model. The most prominent names are Beaver (1965); Altman (1968); Deakin (1972) and Taffler (1983).
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More than the last three decades a large amount of work has been done in the field of predicting corporate failures. The most prominent are Beaver (1968); Altman (1968) and Deakin (1972).
This dissertation aims to develop the Z-score model with the technique of Multiple Discriminate Analysis, and then check the predictive ability of the developed Z-score model. This mainly stress on what are the available methodologies, and the reason for selecting the specific methodology with its benefits as compared to other methodologies.
Secondly it comprises what are the sources have been used to move towards data and how they are going to help to overcome the research problem and sub problems?
Lastly what are the variables used in developing the model including independent and dependent, and for testing the true forecasting ability of model?
Care has been given to the relevant parameters for instance size, nature of sample, activity of industry and average turnover. It has also considered that there should be no unfairness at all in the data selection and interpretation.Data requirements for sub problem 1 for developing the Z-score model
Data for this research was taken from the selection of sixty private UK construction companies. The categorization of the industrial sector and the target population for this research work is the General Construction Industry SIC code is 4521.
The original sample was based on eighty companies, however after careful thought, it was decided that due to time constraints and problems in obtaining and interpreting data, research work will be more focused on the data of sixty companies.
The sample of sixty companies is based on two groups.
Group one comprises thirty failed companies during the period of 2002-2007 and Group Two of thirty companies which are solvent as of 2007 and satisfy Companies Act 2006.
Both of the samples are based on the general construction industry and the legal status of the companies is private limited companies.
Special consideration has been given to data collection, especially size of companies, employees, turn over and the nature of the industry. The data fulfils all the requirements of small medium enterprises under the UK Companies Act 2006 and European Union definition of SME's.
FAILURE FORECAST IN SMALL AND MEDIUM ENTERPRISES
The purpose of this to explain the definition of small and medium businesses' in the situation of the EU and UK Companies Act 2006. It also focuses on the importance of small business and their involvement to the UK economy and what are the possible reasons for small business fall down. Finally it goes on to reproduce on factors that are particular to the construction industry and to the period over which study has been occupied.
DEFINITION OF A SMALL BUSINESS:
There is no precise definition of a small business. The definition of a small business is based on criteria such as number of employees, turnover, capital and profits.
So finally a small business means that a business should have a relatively smaller share of the market than large businesses, secondly the management structure is not big, most probably the business is controlled by its owners and it should be self-governing allowing the owners a high degree of decision making dependence.
The UK Government defines SMEs as follow.
A small or medium-sized company is defined in Section 382 and 465 Companies Act 2006.
That a company is 'small' if it satisfies at least two of the following criteria.
A turnover of not more than £5.6 million.
A balance sheet of total of not more than £2.8 million.
Not more than 50 employees.A medium sized company must satisfy at least two of the following criteria.
A turnover of not more than £22.8 million.
A balance sheet total of not more than £11.4 million.
Not more than 250 employees.
The UK government tends to use employment based criteria for the financial assistance of SME's. For regional project grants SME's should have less than 25 employees, for export awards less than 200 employees.
IMPORTANCE OF SMALL BUSINESSES TO UK ECONOMY
According to the reports of Department for Business Enterprise and Regularity Reform the small businesses offer 47% of UK private sector employment and 37% turn over as compared to large businesses. There are only 6000 businesses in UK which have more than plus 250 employees.
The input of SMEs is important in UK economy and since 1980 there is a main growth in SMEs. According to the figures of DTI (1999) The Department of Trade and Industry stated that SMEs makeup over 98% of the total business population with 2% of all business not being small.
REASONS OF SMALL BUSINESS FAILURE
It is a fact that only 50% of small businesses trade after their first three years from their initial setup and currently they are likely to suffer most because of a disturbing economy and a deteriorating business environment.
Brough (1970) Hall and Young (1999) agreed that the fundamental reason for most of the small businesses failures is the lack of financial resources. They mentioned that owners of small businesses that fail, identifying shortage of capital as a major reason of failure.
Cressy(1999) analysed that those firms have better chances of survival who have steady growth and better capitalised start ups as compared to the fast growth firms with little capital in hand. He also suggested that the better approach is to wait more and arrange the capital resources and obtain enough market knowledge and then embark.
REASONS FOR SMALL BUSINESS FAILURES
Brough (1970) Hall and Young (1999) mentioned in there studies that following are the basic causes of small business failures.
LACK OF SKILLS
Generally the small businesses do not have enough skills (core skills) to run business powerfully. When it mentions skills, it does not mean specific accounting skills but those overall business skills that will be compulsory to lead the business powerfully.
However a staff can be rented for those skills but once again resources are another barrier as well. There are many other vital reasons for small business failures but following are the most common and significant reasons of failures.
Study shows that above 50% of small business are still trading after the first three years of their initial setup,
When a business introduces a new product or service the chances are that demand for that product or service would be very smallest. As a result of that no one would take those products and services.
So the problem with small business is that due to brutal struggle in market which is already existing makes it more hard for small businesses to capture the market and their sale does not grow and finally starts to reject.
There is a universal idea in the business world "no sales result no business; and so it is important to know where and how small business will increase there sales and when they start trading. There should be some market knowledge and market capital and the common of small business are failing in this area.
Another major area where small businesses are failing is because managers do not use accounting and accounting practices in their business and as a result of that business starts having a problem with cash flows, and then an final danger is liquidity and going concern issues.
LACK OF FUNDS
One of the major causes of business failure is the need of start up resources, when businesses start they do not have sufficient resources, to bear the running cost of the business. In case of unexpected events businesses can not manage up and as a result they failed to continue trade.
The best solution to this problem is that wait for one more year gather enough resources and local market knowledge and then go on board rather than failing by starting before being carefully prepared.
HIGH COST OF FINANCE
Another problem of small to medium enterprises is that even if they want to continue the business with the help of funding and loans, and the cost of financing is so high that the business cannot service the cost of debt. High interest rates with critical repayment schedules make it most horrible.
In the current situation availability of finance is a major issue; banks are very unwilling to approve loans even for the massive organisations. Finally it is quite hard for SMEs to arrange the availability of funds.
Every business has natural risk of bankrupt customers however for SMEs this factor could be fatal and as a result of it business could finish especially if the bankrupt customer is a major customer.
For SMEs the possible influence of insolvent customer is important. If business cash flow is not balance then eventually it would not be in such a position to pay of its own arrears. Finally creditors will force for liquidation or voluntarily liquidation will be the last option.
The possibility of a sudden raise in growth motivates the entrepreneurs to increase sales and as a result increase overhead expenses. Due to the interest the financing cost, plus other direct and indirect expenses of SME is increased as a well. Subsequently the SMEs have to rely on high financing cost and unfavourable repayment schedules. As a result of that the business could suffer bankruptcy.
In the business world steady growth is more considerable than fast and rapid growth. In rapid growth SMEs have to have a loan of more money to reimburse for all those costs i.e. staff cost, selling and administration costs and materials to meet all these demands. On the other hand if the customer is doing business on credit rather than a cash. Afterwards cash flow cycle will be not manageable and then insolvency is expected.
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Critical success factors (CSFs) have been used considerably to know a few important factors that a businessmen should focus on to be successful. As a definition, critical success means"the limited number of areas in which satisfactory results will ensure successful competitive performance for the individual,or department" (Rockart and Bullen, 1981). Identifying CSFs is vital as it allows firms to focus their hard work on building their abilities to meet the CSFs, or even allow firms to make a decision if they have the potential to make the needs necessary to meet critical success factors (CSFs).
Success factors were already being used as a expression in business when Rockart and Bullen reintroduced the idea to give better knowledge of the idea and, at the same time, give superior simplicity of how CSFs can be recognized.
CSFs are modified to a firm's or manager's exacting state as different situations (e.g. industry, division, individual) lead to different critical success factors. Rockart and Bullen presented five key sources of CSFs:
An industry's set of features define its own CSFs. Different organizations will thus have different CSFs, for example research into the CSFs for the business services, health care and education sectors showed each to be different after starting with a assumption of all sectors having their CSFs as market orientation, learning orientation, entrepreneurial management style and organisational flexibility (Barrett, Balloun and Weinstein, 2005Competive strategy and industry position
Not all firms in an industry will have the same CSFs in a particular industry. A firm's existing position in the industry (where it is comparative to other competitors in the industry and also the market leader), its strategy, and its assets and capabilities will describe its CSFs.
For example, in 2005 Caterpillar defined a new strategy to forcefully grow revenues over the long term. As part of that new strategy, Caterpillar defined several CSFs specific to the firm which were (Gordon, 2005):
- Organisational culture: "creating a culture that engaged employees, while focusing on safety and diversity"
- Quality control: "accelerating the pace of quality improvement for its products, while focusing on improving new product introduction and continuous product improvement processes"
- Cost focus: "implementing processes to become the highest-quality, lowest cost producer of our high-volume products in each hemispheric currency zone"
Other firms in Caterpillar's industry may or may not have the same CSFs, and are unlikely to have the same complete set.Environmental factors
These speak about to environmental factors that are not in the control of the administration but which an administration must consider in developing CSFs.
Examples for these are the business rule, political growth and financial presentation of a country, and population trends. For example, Ladbrokes, a UK bookmaker, will be establishing an global commerce in Italy where it has just acquired a commerce certify, a condition for overseas sports instruction gambling firms previous to establishing a business in the country (Citywire, 2007).Chronological factors
Chronological factors are provisional or one-off CSFs resulting from a exact event necessitating their addition. Rockart and Bullen (1981) condition that characteristically, a chronological CSF would not live and they give as an example of a firm which "lost executives as a result of a plane crash requiring a critical success factor of rebuilding the executive group". However, with the development and addition of markets internationally, one could quarrel that chronological factors are not chronological anymore as they could live frequently in organisations.business
For example, a definite forcefully building a company globally would have a need for a central group of executives in its new markets. Thus, it would have the CSF of "building the executive group in a specific market" and it could have this every year for different markets.
For example, Bear Stearns has stated an aggressive expansion plan in Asia to grow existing and new business lines (Financialwire, 2007). As Bear Stearns grows its business over the next few years, a CSF in each year is to build its management teams for the business and the financial products that it seeks to expand.Professional place
A final main foundation of CSF is professional place. This is important if CSFs are careful from an individual's point of view. Rockart and Bullen (1981) gives an example of developed managers who would typically have the following CSFs: product quality, inventory control and cash control.
As examples, possible firms whose managers would have the stated CSFs mentioned by the authors include Heidelberg Cement (large global cement firm) (Satish, 2007). An example of CSFs for the five primary sources is shown from a work on enterprise security management (see figure 2) which utilised the CSFs method to develop and deploy an effective approach to their business (Caralli, 2004).
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- Rockart, J. and Bullen, C., 1981. A primer on critical success factors. Center for Information Systems Research Working Paper No 69. Sloan School of Management, MIT, Cambridge, Massachusetts.
- Satish J., 2007. Tata Steel celebrates century with Corus-fired profit rocket. DNA - Daily News & Analysis. [Published 30 August 2007]. Available from: http://www.factiva.com. [cited 8 September 2007].
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