The Framework for Predicting Failure in Trading

 The Framework for Predicting Failure in Trading

You might have read or heard someone envisage or forecast that a particular retail organization or a chain of stores is going shut down due to being on the verge of bankruptcy. Can you remember how many times it did not happen the way you heard about it? Well, it might have happened a few times. Maybe you have also predicted that a store will shut down in the near future because of so and so reasons. Most people think like that.

If you take a look over recent years, you will notice there have been plenty of stores that closed down because of the super ecommerce retailer, Amazon. After the juggernaut was formed, the first ones to be crushed under it because of the financial crisis were Borders, Circuit City and Linen’ n Things. And now economic analysts have identified there could be a next wave of victims that could be destroyed by Amazon, namely Barnes & Nobel, Best Buy and RadioShack. Even Wal-Mart is showing signs of decreased store sales in the domestic division.

So, being an investor, what is the first question that pops into your mind? Of course, you will be asking yourself is it a good to differentiate an actual crisis at a brick and mortar retailer from that of a threatening one, but one that can be survivable? If you can distinguish the threat, you can avert a potentially dangerous investment but also make a profit on the consistent drop or a rebound in the company’s primary stocks.

Why Is It So Complicated To Forecast Failure?

The main reason why predicting failure can be overly complicated or calculating when a company will sink under is because bankruptcy is not just an issue of solvency (having more assets than liabilities), and if things were that simple, even a rookie investor would be able to foresee the downfall of a publicly traded company. Because all that would take is to review and evaluate the company’s shareholder equity portion in the balance sheet.

However, this doesn’t mean that solvency is of no importance, because it does matter. The thing to understand here is that solvency is not the leading cause of failure among companies. Let’s look at a textbook example. Consider the downfall of Circuit City which was a former electronics giant. When Circuit City filed for bankruptcy less than 6 years, it was deemed America’s second biggest electronics retailer and vendor. It had 700 superstores in different shopping malls and centres across the US. And on top of that, before it filed for bankruptcy, the ending balance sheet indicated that the company had $3.4 billion in assets in comparison to their liabilities which amounted to $2.3 billion.

This tells you that the company was not just solvency but it had a book value of over $1 billion. So, if solvency is not the problem here then what is? Quite simply, the answer to the question is liquidity. When an organization or company is in its final struggle, the first and most immediate problem it faces is the failure of converting assets into liquid cash, cash that can be used to pay off expenses such as rent and wages, etc.

This problem occurs when creditors begin to give up hope in the company and stop taking the company’s assets as collateral in order to be paid off. So, basically it is the inability to pay creditors what causes the entire problem, leading to the demise of a particular company and this is what exactly happened with Circuit City.

The Framework for Evaluating Liquidity

When liquidity becomes a problem, the traditional move should be towards the analysis of a company’s current assets, like cash, inventory and accounts receivable, and comparing it with its current liabilities, which could be debts and further obligations to be carried out. However, this method, referred to as  the current ratio analysis, can be both effective and misleading because of the fact that it includes assets which cannot be turned into cash, namely accounts receivable and the inventory, at short notice.

Current ratio also ignores cash flow which is the core of liquidity. Moreover there is also a one-sided aspect to liquidity that cannot be recorded in the financial statements. In essence, everything points towards the creditors of a company. Liquidity depends on the company’s creditors. Because of the fact that creditors are not interested in shorthand measures pertaining to the fiscal prosperity of company, like the current ratio, they are more worried about how they can topple competing creditors, thereby getting their repayments before time runs out.

Predicting Failure: The Bottom-Line

The point of what is explained here is to help you realize it is hard to pinpoint the failure of the companies which are on the brink of shutting down. There are immense complications because the analysis entails more elements than just solvency.

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