RDP 2016-09: Why Do Companies Fail? 7. Conclusion
November 2016
This paper uncovers the key determinants of the risk of failure among Australian companies.
First, structural company-specific factors matter – an apparently novel result in the corporate failure literature. For instance, public companies are much more likely to fail than private companies, on average, with listed companies being most vulnerable beyond about 30 years of corporate life. This is consistent with public companies taking more risk because of the greater separation of ownership and control, particularly later in life. Companies that are subsidiaries of foreign parents are also found to be much less likely to fail than standalone companies.
Second, cyclical company-level factors are also important. These factors include the ‘usual suspects’, such as high leverage and low profitability, with low liquidity playing a particularly important role. The cyclical factors that are correlated with failure are similar for both listed and unlisted companies. However, increases in leverage and decreases in size raise the probability of failure more for listed companies, while ageing reduces the probability of failure more for unlisted companies. Liquidity and profitability matter for all companies.
Third, aggregate conditions are the most important determinant of annual failure rates. Corporate failure is more likely during an economic downturn, even after controlling for changes over time in company-specific characteristics. Company-specific factors, in contrast, provide the information necessary to rank companies in terms of failure risk.
The potential contribution of corporate failure to financial stability risk is measured using a debt-at-risk framework. The estimates indicate that corporate debt at risk is low in aggregate and concentrated among large companies. Furthermore, our results highlight the importance of trade credit, both as a form of leverage that can influence the likelihood of corporate failure, and as a potential channel through which shocks may be propagated. While trade credit accounts for a smaller proportion of liabilities than debt for Australian businesses, its importance to financial stability is increased through its ability to transmit distress between businesses directly.
These results provide guidance as to the characteristics that should be monitored in financial stability surveillance of the non-financial corporate sector. Notably, most of these characteristics are already regularly monitored in the Reserve Bank's semiannual Financial Stability Review. It also provides a model that could be used to create debt-at-risk estimates and expected loss measures for Australian banks' lending to the business sector.