The Stages of Descent into Bankruptcy

Bankruptcy is a common phenomenon in the business world. There have been many cases wherein the stalwarts of yesterday, the companies which were running multi-billion dollar profits, have later filed for insolvency. For the benefit of the readers, let us define bankruptcy. Bankruptcy is the stage at which companies find it financially unviable to function. This means that the cash flows and the profits being generated by the company become woefully inadequate to sustain the normal course of business.

However, it needs to be understood that companies do not descend into bankruptcy overnight. Rather, descent is a long time-consuming process. Companies find it difficult to avoid this process because they are unable to recognize their tell-tale signs.

In this article, we will provide a detailed explanation of the various stages, which lead a healthy company into bankruptcy.

Stage #1: Hubris

In this stage, the stalwarts are blinded by success. Their hubris makes them believe that they are too big to fail. They fail to pay attention to and recognize the internal and external conditions which are changing in the environment. More often than not, there are tectonic technical changes that are happening during this time. For instance, Sony could not see that its Walk Man would soon be obsolete, and Apple would be selling the music of the future through its iTunes store. In this stage, companies are not scanning their external environment carefully enough. Even if they are scanning the environment and recognize the changes, they do not actually understand its significance.

The reality is that businesses continually operate within the context of an external environment. The ability to understand and adapt to the changing environment could mean the difference between continued success and bankruptcy.

Stage #2: Inaction

As more time passes, the changes in the external environment become more visible to the organization. However, there is still inertia in the organization. This is because firstly, these organizations are quite large. Hence, changing policies is not that easy. It becomes even more difficult when the policy that needs to be changed is the reason behind the success that the company is facing. The company in question still does not recognize the urgency of the situation. They are typically slow to act since they do not believe that the challengers pose a serious threat to them.

Stage #3: Incorrect Action

In the next stage, the changes in the external environment become unavoidable, and the organization is propelled towards action. The external environment typically starts affecting the internal environment in the form of high costs, decreased profits, or decreased market share. In reality, most of these are the result of the technological backwardness that the company has acquired by being outdated. However, the managers still do not recognize the fact that the business can only be salvaged by fundamentally restructuring the business. Hence, the managers instead try to make small changes such as cutting costs. Often their actions are not as effective. In fact, they end up making the problem worse since they are treating the wrong cause.

Stage #4: Crisis Stage

The next stage is called the crisis stage. This is because the company is unable to salvage itself, and the economic problems keep getting worse by the day. This is where it starts becoming apparent that the company will not survive for very long. By the end of this stage, the company ends up either bankrupt or ends up being taken over by another corporation.

At this point, the company tries to make desperate attempts to reverse the damage done. Cutbacks and layoffs follow on a large scale. Also, since the company is in trouble, a lot of people willingly leave it to find greener pastures elsewhere. The measures are taken often end up being too little and too late. This is the reason that the odds are stacked against the company at this stage. From a legal point of view, this is the stage when American companies file chapter 11 bankruptcy. Chapter 11 bankruptcy means that the company is still allowed to operate as a going concern.

It is important to note that it is possible to salvage the company from each of the above four stages. This means that the company need not progress onto the next stage but can instead move to the previous stage. However, the process becomes more and more difficult with the passage of time as the company progresses along these stages.

Stage #5: Dissolution

The last stage of the entire process is dissolution. Not all companies which face crisis actually reach this stage. In many cases, efficient management helps in turning around the company. However, if the company does reach this stage, it means that the company is about to file Chapter 7 bankruptcy. Chapter 7 bankruptcy is when the court-appointed trustees take hold of the assets of the firm and sell them. The money received by liquidating the firm is then used to settle the amount owed by the creditors. This is when the firm ceases to be a going concern, and all the employees at the firm also end up losing their jobs.

The bottom line is that bankruptcy does not usually happen overnight. There are clear signals which the firm and the general people receive for years before a bankruptcy actually occurs.