We have seen more than a dozen corporate bankruptcies in the U.S., including corporations, such as WorldCom, Enron, General Motors, and Lehman Brothers, in the 21st century. Several of these firms bounced back, but some ended for good.
Their collapses came about due to a variety of causes, such as fraudulent CEOs, overambitious expansion, or simply disastrous circumstances. Although the differences in size and complexity between corporate finance and an individual’s personal finance is obvious, there are five important lessons to be learned from these corporate failures that we can apply to our own personal finances.
Lesson 1: Taking up too much loan leads to Doomsday
Corporations take up financial leverage for investments or expansions. Financial leverage is the practice of utilising borrowed money to invest in an asset. Leverage can amplify gains when asset prices rise, but it can equally magnify losses when asset prices fall.
Excessive leverage was a major contributing factor to the fall of Lehman Brothers. Lehman’s big push into the subprime mortgage market initially made profits from 2005 to 2007. However, in 2007, its leverage reached a dangerously high level.
For most of us, we often seek financial leverage from financial institutions when we are making big purchases like buying a car, property or even to fund our education.
While a reasonable degree of leverage is not necessarily a bad thing, excessive leverage is generally too risky. Especially leverage on an asset that doesn’t have strong fundamentals. It is only prudent to get loans that you can handle for the asset purchase or investment. Remember that too much of anything is always bad!
Lesson 2: Having adequate liquidity is important
Washington Mutual Bank was forced into bankruptcy because of its bank-run amounting to 9% of its deposits in September 2008. The mass and speed of deposit outflows from Washington Mutual shortened the time available for them to find new capital, improve liquidity or find an equity partner.
Cash is not always king, contrary to popular belief. However, it is when in a bear market. Therefore, it makes sense to have adequate liquidity at all times, in order to meet contingencies and unexpected expenses – for example, an unexpected job loss or a medical emergency.
Don’t put all your money into investment. Always maintain a contingency fund amounting to at least six months of your income, saved in a highly liquid account.
Lesson 3: There often is no shortcut to sustainable wealth
WorldCom CEO Bernard Ebbers was sentenced to 25-year jail for fraud and conspiracy due to the company’s fraudulent accounting and financial reporting. Fraud never pays.
WorldCom was not the only company to indulge in accounting fraud, others including Tyco, Enron and Adelphia Communications, and they all ended in trouble with insider trading and options-backdating scandals. Top executives who were involved in these frauds ended up serving time in jail, paying huge amounts of fines, or fired for providing false information about their educational qualifications on their resumes.
As cliché as it may sound, the key takeaway here is that, honesty is the best policy. There is no get-rich-quick scheme, or shortcuts to millions. Forget about forging your education qualification, or falsifying your resume, or worse, tax evasion.
When one is found guilty, the damage can have a long-term impact on one’s reputation, not to mention finances.
Lesson 4: Be adaptable to remain competitive
General Motors (GM) was once the world’s largest automaker but ultimately lost to aggressive Japanese automakers, such as Toyota and Honda. It ultimately became a victim of its own success, as a bloated cost structure and poor management saw it rapidly lose market share, resulting in its financial position deteriorating at an accelerated pace during the recession in 2007 and 2008.
Learning from GM, we need to be adaptable in our finances and also our investment portfolio to react to the current market and economic climate. Without periodical reviews on our financial goals and portfolio, we risk to lose out on our returns and also opportunities.
Lesson 5: If you don’t understand it, don’t invest in it
With its complex business model, Enron has succeeded in deceiving shareholders through pension funds and other institutional investors for years. At its peak, Enron was worth about $70 billion, its shares trading for about $90 each. But it all came crashing down.
A company that is not fully transparent or uses creative accounting may not be portraying its true performance and financial position.
In the words of Warren Buffett, “Never invest in a business you cannot understand.” This is the key lesson that the Enron bankruptcy holds for investors. As individuals, why bother investing in an investment that is hard to understand, when there are numerous investment alternatives in the marketplace? You can invest your money wherever you want – in unit trust, shares, or REITs. But before you do, it is important to know how it works and the consequences that await if it fails.
These bankruptcies provide valuable lessons to individuals, despite the differences in size and complexity between corporate finance and personal finance. From the perspective of financial planning and personal investments, these lessons are applicable to most individuals, from young investors to seasoned market professionals.