For years, doctrine has tried to provide broad definitions of failure; but in no case has failure been defined rigorously. This gap allows scholars to make subjective assessments.
As the definition of legal failure is legally regulated based on the concept of bankruptcy, suspension of payments or bankruptcy, it is the one that has usually been used because it is considered to provide objectivity to the analysis carried out.
In my opinion, business failure is understood as failure to meet the objectives that the company has set for itself. In this sense, it is necessary to consider which are the objectives whose failure can cause situations of failure. These general objectives of the company depend on the moment and its particular circumstances.
Some objectives stand out, such as: profitability, growth, stability, collectivity… But the real discussion focuses on the polarity between “profitability-security” and “solvency-stability”.
The doctrine groups these objectives into the following groups, which are: creating added economic value, providing a service to the society to which it belongs, obtaining the expected profitability of the investment, achieving security or stability of permanence over time, an allocation efficient resources that, ultimately, guarantee the continuity of the company over time, and the creation of value, as long as continuity over time is ensured.
The relationships that determine the value creation capacity of a company are solvency and profitability:
a) Solvency-financial stability represents the company’s ability to meet the return or reimbursement of its debts. An optimal financial structure must be maintained that allows financial resources to be obtained at the necessary times, for the expected time and at the lowest possible cost, which in turn entails the existence of an adequate relationship between the availability of the asset and the repayment of the liability.
b) Economic stability or profitability-security, which refers to the increase in the wealth of a company in relation to the resources used for it; The best combination of productive factors is sought.
With this, a balance is achieved between non-current assets and current assets that allows maximum profitability to be obtained without endangering the continuity of the company over time.
Solvency and profitability are clearly related, given that profitability is presented as a necessary requirement to ensure the stability of the company. When solvency prevails over profitability, prediction models based on solvency are limited in terms of their application possibilities in terms of business stability and continuity over time. One thing is that profitability is a determining factor of solvency, and another is that profitability does not guarantee solvency:
a) There are companies with positive profitability that have financial liquidity problems that reduce their payment capacity and, therefore, their solvency; b) there are companies with negative profitability, which leads to insolvency – insolvency reduces profitability, becoming negative.
The doctrine has raised different forms of failure, although none has been unanimously accepted.
Different situations can occur: a) Economic failure where different scenarios occur: the profitability of the invested capital is lower than that obtained in other alternative investments; b) the income is not sufficient to cover the costs or the average profitability of the investment is below the company’s cost of capital; c) commercial failure that appears under the following figures: i) businesses that stop operating due to mandate or bankruptcy; ii) foreclosures, foreclosures or seizures; iii) losses for creditors; iv) those who voluntarily withdraw without paying their obligations; v) those who are involved in judicial actions such as interventions, reorganizations or agreements or those who voluntarily reach an agreement with creditors: vi) technical or imminent insolvency: coincides with problems of lack of liquidity; and vii) definitive or current insolvency: when there is negative net worth.
Economic failure and financial failure are interrelated. Normally, the failure process begins when the profitability of own capital is lower than that obtained with similar investments – and is not corrected – and when the income from the operating activity begins to be lower than the expenses, giving rise to to the appearance of negative results.
The maintenance of this situation over time results in more or less serious liquidity problems. If these facts are changed by their equivalent terms, the beginning of economic failure occurs when the profitability of own funds is lower than that obtained by similar investments, reaching the peak point when the existence of losses appears, the prolongation of which in the future. time usually gives rise to liquidity problems, a manifestation of which is financial failure.
In another order of things, business failure prediction models aim to know, with sufficient advance notice, the position of the company, in order to adopt a series of measures to prevent its disappearance.
There are different situations, various difficulties that determine that the measures to be adopted also differ, making it appropriate to discriminate each of the possible situations of failure. Given these circumstances, a large part of the models developed for the prediction of failure seek solutions: 1) From the verification of healthy companies that continue to operate in subsequent periods; 2) until the use of a previous model that discriminates between companies with or without financial problems from those defined as not bankrupt.
Despite everything expressed, it is advisable to use a broad concept of failure that reflects the true economic or financial situation of the company, without limiting itself to legal aspects.
Furthermore, various states of failure must be differentiated, since economic reality shows that companies can go through different difficulties, for which different measures are adopted, ranging from simple economic or financial imbalances of a temporary nature to others of a structural nature that can lead it to very different situations in the future – such as the deferral of debts or the renegotiation of its conditions, until the definitive closure of the company.
Lawyer, economist, auditor, doctor and professor of the Fiscal System. Founding partner of Firma Martín Molina
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