In this paper the author shows the ways to asses the bankruptcy risk using a related system of methods: economic, managerial, banking and statistics. At the end of this paper is addressed this issue with the help of Robertson Model.bankruptcy risk, economic risk, financial risk

Moscviciov Andrei

English

Research Papers in Economics

￿
419 
THE RISK OF FAILURE - CAUSES AND CONSEQUENCES OF THE IT 
INDUSTRY 
Moscviciov Andrei 
Faculty  of  Economics  and  Business  Administration  Babe￿-Bolyai  University,  Cluj-Napoca, 
Romania 
 
In this paper the author shows the ways to asses the bankruptcy risk using a related system of 
methods: economic, managerial, banking and statistics. At the end of this paper is addressed this 
issue with the help of Robertson Model. 
 
Keywords: bankruptcy risk, economic risk, financial risk  
 
JEL Classification: G32 
 
1. Introduction 
Business  activity  is  subject  to  risk  at  any  time.  In  general,  it  is  considered  that  risk  is  the 
probability that an undesired event occurs.  
Depending  on  its  market  position,  economic  and  financial  situation,  economic  environment, 
respectively the climate in which it operates, a company can support more difficult or easier the 
risks is subject to. Basically there is no economic activity in which risk does not interfere at a 
certain time. But its intensity may be different depending on the field, market trends, image of the 
country in the global context, etc. 
 
2. Method and Results 
Companies are usually subject to the following types of risk: economic, financial and bankruptcy. 
Financial welfare diagnosis is a means of obtaining accurate and qualitative information about 
the real possibilities of the company at the beginning stage of the economic crisis. A company 
with a serious analytical system is able to recognize in time the approaching crisis. With the help 
of  financial  analysis  can  be  found  vulnerable  spots  in  the  company’s  economy  and  can  be 
proposed efficient solutions for the company to get out of the difficult situation. 
In our opinion, bankruptcy risk can be defined as the inability of firms to cope with a financial-
banking transaction, namely their inability to reimburse in time the sums borrowed under the 
conditions agreed with the banks in the credit contracts. The risk of bankruptcy can be the result 
of  difficulties  showing  up  that  initially,  at  the  analysis  stage  and  also  credit  evaluation  and 
approval stage could not be identified, but occurred during the contract. Therefore, the diagnosis 
process of failure risk is to assess the firm's ability to meet commitments to others, therefore in 
the assessment of company’s solvency. 
 
With the purpose of analyzing risk, experts rely on the financial theory that provides a series of 
concepts that have enabled the recent opening of the financial analysis of the company. The 
traditional approach of financial diagnosis, widely inspired by the concerns of bankers, the risk 
was perceived as a risk of insolvency. From this point of view the customer’s financial analysis is 
divided into several stages: working capital cycle analysis; analysis of performance indicators; 
analysis of capital structure, indebtedness; liquidity analysis. 
In the area of risk in lending, financial analysis was focused mainly on critical assessment of 
credit  records,  ran  from  a  banking  point  of  view.  Its  analytical  scheme  could  be  therefore 
summarized to two basic points: ￿
420 
-  companies  address  to  banks  or  other  financial  institutions  a  credit  application,  in  general 
conditions of excess of demand over supply; 
- financial diagnosis should allow the selection of applications, eliminating those with very high 
probability of non-recovery (i.e. those with high risk) and thus making the adjustment between 
demand and credit offer. 
As in the financial theory is prevalent the concept which defines risk through the variability of 
results and increasing instability of company’s performance, now found worldwide, it can not 
remain unexplained, financial analysis has widen the risk concept linking it first to the notion of 
financial  flexibility,  namely  the  ability  of  companies  to  adapt  financially  to  environmental 
change. This is because the risk is seen now by the outcome variability, variability that is better 
controlled by the company as it has a high degree of flexibility. 
The  analysis  (diagnosis)  of  risk  perceived  by  the  company  can  go  along  with  the  company 
capacity analysis to cope with this risk (i.e. the flexibility analysis), the two analyses are not 
totally identical; a true analysis of financial flexibility is needed more to a strategic diagnosis 
than a financial one. Secondly, broadening the concept of risk of financial analysis was done by 
deepening  companies’  difficulties  study  and  by  the  more  elaborate  analysis  of  the  risk  of 
bankruptcy. Financial diagnosis received these new tools in its efforts, aspect reflected by the use 
of the notions: “financial leverage effect”, “operating leverage effect”, “scores” or “ranks”. The 
rank  consists  in  grading  or  classifying  securities,  being  subject  to  transactions  on  a  capital 
market, using a synthetic indicator in the study of results and cash flows that generate problems 
to the companies and bankruptcy risk analysis. 
Even  though  statistically  it  was  found  that  the  frequency  of  strictly  financial  difficulties  is 
limited,  financial  analysis  comes  with  important  contributions  in  studying  and  treating  the 
companies’  difficulties  as  all  causes  of  degradation  ultimately  have  a  direct  impact  on 
performance or financial position. 
Traditional contributions of financial analysis to detect “risk businesses” are related to the use of 
its instruments: balances, rates, flow panels, etc. The multitude of indicators provided by these 
tools has made necessary the search for global notation (SCOR), allowing taking into account 
only significant indicators and highlighting the interdependences of different features that they 
translate. One can thus achieve empirical or statistical risk detection. 
 
Credibility  represents the material  and  moral  support,  the  essential  element  without  which a 
credit may not be granted. Gaining trust requires knowing the customer which is produced by an 
activity  of  analysis  and  documentation,  so  that  an  assessment  as  close  to the  real  asset  and 
financial situation is done, recognition of manufactured products and services, relationships with 
partners, professionalism of management. When lending, the bank takes a credit risk, reduced by 
a careful evaluation of the borrowers, establishing exposure limits and implementing a prudent 
provisioning policy when there is danger of loss. 
Investigation of customer activity in order to know him is pursued and completed by the analysis 
of creditworthiness, which allows on the one hand reducing the credit risk and on the other hand 
establishing an image of the client and the uncertainty degree incurred by the bank in order to 
make the decision to continue the customer's analysis for credit approval. 
The risk of the requested loan default is generated by: 
- borrower’s inability to generate adequate cash flows as a result of adverse events in business 
activity due to economic and political environment; 
- uncertainty about future value and quality, the liquidity degree and the market value of debtor’s 
collateral materials; 
- borrower’s business deterioration. ￿
421 
For this, through the financial analysis the bank seeks to identify and quantify the risk of client’s 
performance, liquidity risk and the risk of capital structure and financing. 
Customer creditworthiness is ascertained using the indicators that define it and express his 
ability to pay his obligations about to assume by signing the credit agreement. 
Bankruptcy risk analysis can be achieved using some methods, which in terms of the form of the 
link between phenomenon (the company’s solvency) and its influence factors can be grouped in 
my opinion into four categories (Fig. no.1) (management methods, economic methods, statistical 
methods and banking methods), which will be discussed below. 
 
 
 
Figure no.1 Methods of analyzing the bankruptcy risk  
 
Professor Robertson identified four elements that produce changes in the firm’s financial health, 
namely:  market  stability,  lower  profits,  lower  working  capital,  and  loan  growth.  Professor 
Robertson scoring function is as follows: 
 
in which: 
Turnover
s TotalAsset Turnover
X
) (
1
−
=  
Assets Total
Exercise Financial the of sult Gross
X
.
. . . . Re
2 =  
s Liabilitie Total
s Liabilitie Total Assets Current
X
.
. .
3
−
=  
s Liabilitie Total
Loans Equity
X
.
4
−
=  
 
Loans
Overdraft assets Liquid
X
−
= 5  
 
Z function aims to the changes that occur in the firm’s financial situation from one period to 
another. If the Z score depreciates by 40% or more than 40% in one year, automatically the 
analysis should identify the causes of Z score reduction. If the score is 40% or over 40% in two 
consecutive years, then the company cannot survive because of its financial instability. 
An alternative to the scoring method, practiced in particular by banks is “normative comparison”, 
the creditworthiness of traders who use credit, which is shown below (St￿nescu, I￿f￿nescu and 
B￿icu￿i 1996: 250). 
   
￿￿￿￿￿￿￿
￿￿￿￿￿￿￿￿￿￿￿
￿￿￿￿￿￿￿
.￿￿!￿￿￿
￿￿￿￿￿￿￿
&￿￿￿￿&￿￿!￿
￿￿￿￿￿￿￿
(￿￿￿￿￿￿￿￿￿￿￿￿
422 
 
Table no. 1  Robertson Model applied to Romanian IT companies 
              Lei 
  Romania     Accomplished  Accomplished  Accomplished  Accomplished  Accomplished 
        31.12.2005  31.12.2006  31.12.2007  31.12.2008  31.12.2009 
  Turnover-total assets     -  7 624 111  -  5 047 945  -  12 558 790  21 689 617  -  13 663 574 
  Turnover      140 229 348  132 240 400  108 031 499  157 175 823  115 939 144 
1)  X1    -0.05  -0.04  -0.12  0.14  -0.12 
  X1 Variable  3  -0.87  -0.61  -1.86  2.21  -1.89 
               
  Gross Result of the Financial 
Exercise    28 726 444  55 740 758  60 162 886  62 475 813  58 384 878 
  Total Assets    147 853 459  137 288 345  120 590 289  135 486 206  129 602 718 
2)  X2    0.19  0.41  0.50  0.46  0.45 
  X2 Variable  3  0.57  1.23  1.50  1.38  1.35 
               
  Current  Assets-Total 
Liabilities    3 546 223  -  2 432 872  -  1 242 828  11 662 140  8 257 559 
  Total Liabilities    140 229 348  132 240 400  108 031 499  157 175 823  115 939 144 
3)  X3    0.03  -0.02  -0.01  0.07  0.07 
  X3 Variable  0.6  0.02  -0.01  -0.01  0.04  0.04 
               
  Equity-Loans    65 201 453  59 890 440  65 303 125  77 807 369  82 598 422 
  Total Liabilities    140 229 348  132 240 400  108 031 499  157 175 823  115 939 144 
4)  X4    0.46  0.45  0.60  0.50  0.71 
  X4 Variable  0,3  0.14  0.14  0.18  0.15  0.21 
               
  Liquid Assets –Bank Overdraft    63 040 644  56 389 075  39 236 476  45 743 659  40 783 983 
  Loans    4 959 388  2 858 135  2 063 490  2 571 055  2 879 304 
5)  X5    12.71  19.73  19.01  17.79  14.16 
  X5 Variable  0,3  3.81  5.92  5.70  5.34  4.25 
               
  "Z" SCORE VALUE     3.67  6.66  5.52  9.12  3.97 
          182%  83%  165%  44% 
 Source: Author’s calculation.  
 
The data analysis shows that except for 2009, IT companies in Romania have not had financial 
problems.  
 
3. Causes of Bankruptcy 
The causes generating difficulty for the company have different origins. From statistical studies 
done over longer periods of time was found that about 51% of the causes generating bankruptcy 
are those from socio-economic and competitive environment in which the company works: 
- increasing national and international competition; 
- emergence of substitute products; 
- loss of a major customer or his bankruptcy; 
- bankruptcy of an important supplier that provides certain materials, parts, components essential 
for the continuation of the company’s work; 
- bankruptcy of a bank with which the company had prevailed relationships; 
- the emergence of more stringent regulations on safety line and environmental protection; 
- continuous drop in the stock market quotation for listed companies. 
In another order of ideas one should also consider domestic nature causes which led to at least 
half of the bankruptcies according to statistics. These causes are overwhelmingly related to poor 
management: 
- stock and customer rotation lower than the rules of the sector; 
- the practice of lower margin than similar businesses; 
- repeated losses from operations; ￿
423 
- inability of credit renewal. 
An attempt to systematize the many causes generating difficulty states or even bankruptcy may 
take into account the following grouping criteria: 
 
a. Causes related to the reduction of activity: 
- the downward trend in demand for products made by the company; 
- loss of key customers; 
- declining competitiveness of the company’s products; 
- low degree of renewal of products, respectively adapting to needs; 
- conjectural decrease in demand; 
- enhanced national and international competition; 
- bankruptcy of major suppliers. 
 
b. Cases related to reducing margins and profitability: 
- inadequate strategic decisions; 
- selling price rigidity; 
- too high staff costs; 
- the existence of fixed assets technically obsolete; 
- the large share of financial charges; 
- unexpected increases in raw material prices. 
 
c. Specific cases related to company’s treasury: 
- difficulties in getting loans to finance; 
- long term stock rotation; 
- term extension of clients’ credit; 
- term reduction of supplier’s loan 
 
d. Specific causes to the management system: 
- managers’ inadequate training and inability to adapt to new market conditions; 
- misunderstandings between members of management; 
- poor analytical accounting and failing to recognize the full cost; 
- lack of substitutes for current leaders; 
- excessive compensation of managers. 
 
e. Accidental causes: 
- misappropriation of funds; 
- natural disasters; 
- internal social problems. 
From the above mentioned factors, it can be concluded that among the causes of bankruptcy the 
following prevail: 
-  poor  management,  which  seems  to  be  the  basis  of  over  50%  of  all  bankruptcies.  Key 
management errors are: bad financial advice, lack of communication with employees, loss of 
control over costs, inadequate marketing policies, production overcapacity etc. 
- internal problems: unskilled labor, loss of important projects, image degradation, fraud, waste 
above the maximum allowed level;  
- external factors: competition, company’s life cycle; it is known that all products, services and 
even companies have a limited life; economic recession, disasters etc. 
 
   ￿
424 
4. Conclusions 
Bankruptcy risk and investor presents interest both to an investor and to a company’s manager. 
Many researchers and financial institutions were and are concerned with developing a method for 
predicting the risk of bankruptcy starting from a group of rates closely related with companies’ 
health or weakness. This is why many researchers found that measuring bankruptcy risk can be 
established through an empirical function which allows estimating the probability for a company 
to record losses and therefore be unable to honor its obligations to customers and to the banks 
which provided loans. 
The main hypothesis of the classical fundamental analysis is to continue the company’s future 
activity. When this probability to continue the activity falls significantly, investors are interested 
in estimating it in order to mitigate potential losses. 
It seems absurd considering the bankruptcy of companies listed on the stock  market, as it’s 
generally  known  that  the  stringent  criteria  for  admission  to  be  listed  on  the  stock  market, 
regarding certain high levels of profitability and capitalization over the last 2-3  years, allow 
listing  on  the  capital  market  only  to  very  competitive  and  with  a  strong  financial  position 
companies. 
But famous cases of sudden bankruptcy of companies listed on international capital markets is no 
longer  news  to  investors.  Thus,  rapid  degradation  of  financial  performance,  coupled  with 
managers’ talent to “cover up” the actual results of listed companies, have imposed the need to 
elaborate some models of quick prediction of their success or failure. 
 
5. References 
- Articles in journals: 
1.Beaver, W.H., „Financial Ratios and Predictors of Failure, Empirical Research of Accounting: 
Selected Studies”. Suppliment to Journal of Accounting Research, No.4(1988). 
2.Brown,  Lawrence.  D.,  Pinello,  Arianna  S.  „To  What  Extent  Does  the  Financial  Reporting 
Process Curb Earnings Surprise Games?”. Journal of Accounting Research 5(2007). 
3.Carslaw, Charles A., Mills, John R. „Developing Ratios for Effective Cash Flow Statement 
Analysis”. Journal of Accountancy (1991). 
4.Crane,  Matthew,  Dyson,  Robert  A.  „Risks  in  Applying  the  New  Business  Combination 
Guidance to Intangible Assets”. CPA Journal 79(2009).  
5.Davis,  Michael,  Largay,  James  A.  III.  „Consolidated  Financial  Statements”,  CPA  Journal 
78(2008). 
6.Epstein,  Barry  J.,  Jermakowicz,  Eva  K.  „IFRS  Converges  to  US  GAAP  on  Segment 
Reporting”. Journal of Accountancy 207(2009): 50. 
7.Epstein, Barry J. „The Economic Effects of IFRS Adoption”. CPA Journal 79(2009). 
   

Consolidated Financial Statements”,

Developing Ratios for Effective Cash Flow Statement Analysis”.

Financial Ratios and Predictors of Failure, Empirical Research of Accounting: Selected Studies”. Suppliment to

Risks in Applying the New Business Combination Guidance to Intangible Assets”.

The Economic Effects of IFRS Adoption”.

To What Extent Does the Financial Reporting Process Curb Earnings Surprise Games?”.

THE RISK OF FAILURE - CAUSES AND CONSEQUENCES OF THE IT INDUSTRY

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THE RISK OF FAILURE - CAUSES AND CONSEQUENCES OF THE IT INDUSTRY

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