turnaround stories II

FINANCIAL DISTRESS AND CORPORATE
TURNAROUND: A REVIEW OF THE LITERATURE
AND AGENDA FOR RESEARCH


Dah-Kwei Loui* and Malcolm Smith**


* Chilee Institute of Technology, Taiwan
**School of Accounting, Finance & Economics, Edith Cowan University

Address for Correspondence
Professor Malcolm Smith
School of Accounting, Finance & Economics
Edith Cowan University
100 Joondalup Drive
Joondalup WA 6027
Western Australia
Tel: (08) 6304 5263
Fax: (08) 6304 5271
Email: Malcolm.smith@ecu.edu.au
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Financial Distress and Corporate Turnaround: A review of the literature and
agenda for research
ABSTRACT

A considerable body of research aims to discriminate between companies with the
potential to stem decline, or recover from extremis, from those which will ultimately
fail. The literature spans a number of academic disciplines and embraces theorising,
case studies and anecdote. Even so much confusion remains regarding the
circumstances where recovery is feasible, and those factors and strategies likely to
facilitate such recovery. This paper reviews this literature by focusing on the
turnaround decision, the process and problems of reorganization and the probability of
its success. Categorization of studies centres on the turnaround process to facilitate
the generation of an analytical overview of findings with regard to alternative
strategies which are a precondition for success. The paper concludes with a future
research agenda embracing an alignment of strategy, implementation approach and
the sources of financial distress.















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Voluntary administration legislation allows companies to reorganize their affairs and
make arrangements with creditors to the point where they can continue trading. The
survival of an ailing business, or at worst improved returns by avoiding immediate
liquidation, can be extremely beneficial to stakeholders. However, this legislation
currently also provides incentives to prolong the existence of non-viable companies,
so that the gap between the incidence of ‘financial distress’ and eventual ‘corporate
death’ has become increasingly complex. Efficient managerial decision-making can
give a company the opportunity to survive; but some organizations will be beyond
help, and it is important that we can avoid unnecessary time and expense by
distinguishing between the two. The following review of current turnaround literature
categorises, summarises and compares the analyses and findings of important studies
in this field.
1. The Turnaround Decision
Routledge and Gadenne (2004) recognise the importance of the role of decision-
makers, their behaviours and their relationship with information cues. They develop
statistical models to clarify and investigate these issues. Their first step was to
examine the ‘reorganization event’, the actual decision as to whether a company
should set about reorganization, or decide to liquidate as soon as it enters voluntary
administration. Routledge and Gadenne recognise the work of Bulow and Shoven
(1978), White (1980, 1983 and 1989) who demonstrate the importance of information
to the potential coalitions of decision makers, including equity-holders, managers and
different groups of creditors.
Over the last thirty years, particularly in US, the concept of financial distress has
changed radically, partly because of major changes in both the law and the markets.
Firstly, the number and the scale of bankruptcies have increased greatly, since the
adoption of the 1979 Bankruptcy Reform Act. Secondly, companies have increasingly
substituted public original-issue high-yield debt for commercial loans, and the number
of investors buying and selling in and out of distressed firms, sometimes to the extent
of participating directly in their reorganisation, has ballooned. This added complexity
has increased the time-lag between the onset of irreversible ‘financial distress’ and
‘corporate death’ with an associated impact on claimholders.
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Clear, reliable information can be particularly difficult to obtain or verify during a
period of financial distress. Even the valuation of a distressed firm can be so complex
that decisions about potential action are extremely debatable. A major problem is for
claimholders to determine whether a company is insolvent on a stock as well as a flow
basis, making precise definitions important here. Wruck (1990: 421) describes
insolvency as “A stock-based definition describes as insolvent a firm with a negative
economic net worth: the present value of its cash-flows is less that its total
obligations.”, which equates to Altman’s (1968) “insolvency in a bankruptcy sense”,
whereas Wruck’s “A firm in financial distress is insolvent on a flow basis, it is unable
to meet current cash obligations.”, equates to Altman’s “technical insolvency”.
Investors must be aware of the history of a company’s cash flows, as well as being
able to predict future cash flows. Reorganization policies are required by both
concerns for company value maximization and by a variety of groups’ self-interest.
Where these two factors clash considerable resources will be required to resolve the
problem.
However, there will inevitably be conflict of interest over the best way to resolve
distress, as different reorganization policies will distribute wealth in different
proportions between shareholders, creditors and managers. This may even lead to bias
or inaccurate data being presented by groups pursuing their own ends (e.g., Kaback,
1996; Dalton & Dily, 2001). The possibility of value-destroying behaviour and
decisions is strong; in the most extreme cases prolonged controversy can be the ‘last
straw’ leading to corporate death.
It is important, then, that managers and claimholders share as much accurate
information as possible. Managers may contribute the best information about internal
operations, whereas creditors or shareholders may themselves have (or employ
specialist analysts who have) a better assessment of external factors such as the
effectiveness of top management etc. It may be that, in extremis, information flow
may be the crucial difference between success and failure in turnaround, and should
therefore be taken into consideration in any assessment.
Despite this environment of conflicts of interest and imperfect information, financial
distress is often resolved through private workouts or legal reorganization (in US,
under Chapter 11 of their Bankruptcy code). For example, according to Gilson (1989,
1990) and Gilson, John and Lang (1990) using New York and American Stock
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Exchange companies, where performance over three years had put them in the bottom
5%, while 51% became distressed, either defaulting or restructuring their debt; 49%
did not. Yet, even among distressed companies, 47% were able to resolve this
distressed state through private negotiation with creditors, without ending up in the
bankruptcy courts. Other studies (e.g., Weiss, 1990; Morse & Show, 1988) have
shown, respectively, that of 95% of companies emerging from Chapter 11 with
reorganization plans, only 5% were eventually liquidated; and that of 60% of those
emerging from Chapter 11 with reorganization plans, 7% merged with other
companies and 15% were eventually liquidated.
Gilson et al. (1990) further found that the higher the ratio of bank debt to total
liabilities, the higher the probability of private renegotiation. On the other hand, the
more complicated the company’s capital structure and the larger the number of classes
of debt, the less likely that private renegotiation would be successful. Less obvious
was their finding that when a company’s ratio of market value to replacement cost of
assets was higher, private renegotiation was also more likely. The suggested
implication is that private reorganization is more probable in companies whose
activities generate significant intangible assets.
White (1983, 1989) emphasise the incentive that equity holders have to avoid
liquidation, which would eliminate their holdings, and that managers, through self-
interest in the preservation of their own jobs, may be said to act as agents for equity-
holders. Therefore, where equity commitment remains, the probability of
reorganization should increase. Indications that the going-concern value of the firm
(minus the costs of reorganization) would exceed its liquidation value (future
profitability), or that levels of liquidity will be high enough to pay off unsecured
creditors, also promote the possibility of reorganization .
In many financial studies, the focus has been on the cost of distress and financial
restructuring costs, rather than potential benefits. However, numerous researchers
(e.g., Kaplan, 1989, Smith, 1990, Baker & Wruck, 1989, Kaplan & Stein, 1990)
concur in their findings that distress is often accompanied by comprehensive
organizational changes in governance, management and structure which can create
value by improving the use of resources and improving efficiency. Financial distress
can actually overcome inertia and force management to rethink, producing change and
adaptation to a depth and scale unlikely to have occurred otherwise.
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Costs of Financial Distress would normally comprise:
a) Out of pocket or direct costs including the legal, administrative and advisory
fees that the company must pay, and which are the easiest to measure. Hence,
for US, Gilson et al. (1990) compute the median cost of restructuring debt to
be 0.32% of the company’s total assets, as measured at the financial year-end
closest to the event, whereas other studies (e.g., Warner 1977, Altman 1984,
and Weiss 1990) estimate actual bankruptcy costs to between 6.6% and 9.8%
of market value, almost ten times more than when private debt restructuring is
possible.
b) Indirect costs, as opportunity costs, are incurred when a company can no
longer carry on its business as usual. It may have lost the right to make
decisions, such as to sell assets or spend money, without the delays associated
with seeking legal approval. Demand for its products may fail, if their value
depends on or is affected by the company’s future performance or survival,
whereas production costs may increase if suppliers include a risk premium in
their prices, tighten credit terms or withdraw. It may even be necessary to
include the cost of stress on management and the time and energy they divert
solely towards managing, then resolving, immediate problems.
Routledge and Gadenne (2004) operationalised these factors as financial ratio
variables in statistical models, representing both the reorganization event, and the
‘performance event’. This latter was the second stage of the research, examining how
useful financial data was in determining whether a company would successfully
reorganize (which they defined as its returns on assets for the next three years
equalling or exceeding the industry average.) Controls for company size and industry
classification were included, as previous research by Hotchkiss (1995) and White
(1983) had found significant links between these factors and potential success or
subsequent failure.
Results showed that increase in the debt-to-assets ratio and decreases in the debt-to-
equity ratio were significant indicators of reorganization being more likely, as were
higher levels of short-term liquidity. It was confirmed that industry classification also
affected the decision. The model also concluded that unsecured creditors and equity
holders determined the reorganization decision. As both models had the same
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variables, useful comparisons could be drawn. For example, one important and
perhaps surprising, result was that although past profitability was an important
variable in distinguishing suitable candidates for reorganization, it was not significant
in the decision model. This might indicate that going-concern value was not the main
concern of ‘coalition’ decision-makers.
The Role of Decision-Makers
Having established the relative importance of certain financial data to the decision
making process, Routledge and Gadenne (2004) then examine the decision-making
performance of insolvency practitioners, important in their role as appointed
administrators.
The theoretical background on which they based their process was that of the
Brunswick (1952) Lens Model, and subsequent studies by Libby (1975), Zimmer
(1980), Abdel-Khalik and El-Sheshai (1980), Casey (1980 and 1983) and Houghton
(1984). Here differentiation is made between imperfect information and imperfect cue
utilization when imperfect decisions are made. By examining how the latter might be
improved by reference to environmental models, Routledge and Gadenne (2004)
show how their efficiency could be improved, particularly as past research had shown
that subjects consistently used variables that were different from successful
discriminators.
Although only a small sample was possible and the experimental task may itself have
lacked realism, results suggested that the individual decision accuracy was
significantly lower than that of environmental models. This was so both as to the
reorganization decision and in selecting, from a group of distressed companies, those
suitable for reorganization. Experience did prove useful in improving accuracy in
identifying companies that should be liquidated, but did not improve accuracy in
identifying companies that were likely to reorganize. This may reflect the decision-
makers’ unconscious operational bias towards avoiding the more expensive
misclassifications in ‘real life’.
On the other hand, the statistical model that was developed for discriminating
between successful and unsuccessful companies achieved high classification
accuracy, and a possibility for further research may be the investigation of different
financial ratios as measures of the constructs used in these models. Other possibilities
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might be the inclusion of relevant non-financial ratios, such as managerial behaviour,
creditor behaviour and as has already been discussed, the influences of differently
composed coalition behaviour on decision outcomes.

2. The Turnaround Process
Chronological Context
“The identification of appropriate managerial responses to financial decline has
become increasingly important. There is mounting evidence that
In US, for example, business failures more than quadrupled between 1979 and 1985,
perhaps partly due to the historical atmosphere and overwhelming concern with
expansion and growth.
“In the past, the inevitability of growth---economic, population, and technological
growth---made the task of cutback unimportant…moreover for most
organizations…growth itself was a primary goal” (Behn 1983:310) This almost
exclusive concentration on strategic planning for strong firms had meant that up until
this point there was no unifying theory to guide research into business level
turnaround. As a result, a number of authors (e.g., Altman 1983, Nystrom & Starbuck
1984, Robbins 1993) have noted that traditional turnaround efforts result in failure far
more often than in success. The associated, and increasingly abundant literature, falls
into three convenient groups, concerned respectively with successful recovery
strategies, the turnaround process and response to specific crises.
a) Successful Turnaround Strategies
Schendel, Patton and Riggs (1976) concentrated on analysing the original causes of
decline, categorizing them according to whether they resulted from a failure to adapt
to changing situations (poor strategies), from inefficient, costly or disrupted
operations or from overall ineffective implementation of apparently sound strategies.
They developed a ‘turnaround’ model which emphasized the importance of correctly
identifying and assessing the cause/causes of failure so that both operating and
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strategic components should be included, and noted that turnaround efforts were most
usually accompanied by changes in top management.
Further research by Schendel and Patton (1976) demonstrated that there were strong
differences in certain variables describing companies achieving success in turnaround.
Here increased cash flow, inventory turnover and new equipment and plant reflected
an increased rate of investment, whilst market share also grew. Conversely cost-to-
sales and value-added decreased.
Hofer (1980) extended these studies by suggesting the importance of including the
degree, the pattern and the time frame of any decline in turnaround research. He
supported the conclusion that the type of responses should fit the original causes of
decline, but also theorized that the severity of the decline should dictate whether cost-
cutting should only be undertaken in operations or, more aggressively, in asset-
reduction as well.
Up until this point, research had been based on case studies and had established the
theory of strategic moves being of major importance to turnaround success, but
Hambrick and Schecter (1983) applied empirical testing to the current concepts. They
set out to identify and prioritise those strategies already theorized as leading to
successful turnaround, by representing them through multiple variables. They then
categorized them as efficiency strategies (concentrating on cost-cutting and / or asset
reduction leading to improved profits) or entrepreneurial strategies (which
concentrated on longer term generation of revenue and market repositioning), and
found that both types were significantly related to successful turnaround. Most
importantly, they provided empirical evidence that, even within mature or declining
industries, companies following efficiency or operating recovery strategies might
achieve turnaround.
O’Neill (1986) provided case study evidence to support these findings, leading him to
theorize about the essential investigations necessary in selecting a successful
turnaround strategy. He decided that not only the initial cause of the decline and the
need for new personalities, thinking and planning in management, but also internal-
organizational and external-environment factors, (such as stage of product life-cycle,
competitive position and industry type) all had to be addressed. He then further
categorized four theoretical primary turnaround strategies as Management (which
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included not only drastic replacements of staff but also tackling problems of
motivation in the rest of the workforce, and redefining the business itself),
Restructuring (which included changes in the framework of the actual organization,
new production methods etc.), Cutback and Growth (the latter two similar to other
researchers’ thinking). Importantly O’Neill then examined the relationship of these
strategies to external, contextual factors, concluding, in support of Hambrick and
Schecter (1983) that although growth as a successful strategy would be severely
constrained by strong competition, cutbacks and restructuring could be successful.
Ramanujam (1984) and Thietart (1988) also followed similar lines of enquiry.
b) The Turnaround Process
Bibeault (1982) theorized that there were four key factors in achieving successful
turnaround. A financially and competitively viable core operation had to be identified
and achieved (if necessary by ‘slimming down’ operations), employee motivation had
to be maintained or increased, sufficient financing had to be negotiated to bridge the
turnaround period providing resources for innovation as well as maintaining operation
and there had to be new, energetic, competent and fully-supported management in
place. All of these factors were seen as being interdependent. Conversely, it was
suggested that failure to achieve successful turnaround was due to indecision,
ineffectiveness or ill-judgement on the part of management, ill-considered or poorly
applied turnaround strategies or inability to arrange sufficient financial recourse.
Bibeault (1982) also introduced the concept of a two-stage model of turnaround,
based on his own observations, supported by reported usage (e.g., Goodman 1982,
Slatter 1984, and Slatter and Lovett 1999). This suggested that ‘emergency’ strategies
to address financial crises and ensure a positive cash flow, and hence immediate
survival, must be combined with ‘stabilization’ plans to streamline and improve the
company’s core operation. He agreed with Hofer (1980) that the severity and duration
of this first phase depended on the severity of the company’s financial plight.
After this stage, Bibeault theorized a decision point, where a company had to decide
simply to continue its previous strategies, in a scaled-down, refined form, or whether
it would pursue new recovery strategies with return-to-growth, development and
increase in market share as objectives.
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Slatter’s (1984) case studies supported previous researchers’ identification of certain
key factors for turnaround success, but also suggested strong central financial control,
yet with organizational change and decentralization of power (Slatter and Lovett 1999)
and leadership (Slatter, Lovett and Barlow 2006) as being important
Grinyer, Mayes and McKiernan (1988) and Grinyer and McKiernan (1990)
investigated the original causes of decline, but concentrated on those specific events
which initiated changes in company strategies, and on both the differences and
similarities between gradually occurring change and change that was enforced and
precipitated by circumstances. Here, they introduced the theories of ‘critical
threshold’ and ‘sharpbenders’ (those companies achieving sudden dramatic
improvement in performance). Their conclusions reinforced previous findings as to
different strategies being appropriate to different phases of turnaround.
Building on this latter concept Robbins and Pearce’s (1992) case study provided
further evidence that ‘retrenchment’ strategies were a crucial first stage of successful
turnaround, their type and extent largely depending on the severity of the failure.
Their exploration of the reasons for this produced certain theoretical conclusions; that
economic decline having reduced a company’s resources, it was essential to safeguard
what remained, as a first step towards rebuilding resources through asset
redeployment. Only achieving this could provide the flexibility needed for strategic
redirection, not only overcoming the costly problems created by present, failing
strategies but also enabling the potentially expensive implementation of new strategic
initiatives. Therefore, ‘retrenchment’ would be essential both to stabilize the situation,
maintaining the company’s viability, and to finance recovery strategies, whatever
form these might take. Subsequent work by Smith and Graves (2005) substantially
supported these findings.
c) Response to Crises associated with Poor Performance.
A number of studies (e.g., Hedberg, Nystrom & Starbuck, 1976; Nystrom & Starbuck,
1984 and Starbuck, Greve & Hedberg, 1978) examine crises associated with
performance problems, where the performance issues are not so severe as to threaten
the survival of the enterprise. These studies attempt to differentiate and explain the
distinct stages of response and the determinants and influences involved, such as
management changes or available financial resources.
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An Integrated Two-Stage Model
Robbins and Pearce (1993) reviewed, summarized and integrated the most important
conclusions of the literature up until this point, importantly drawing on multiple
disciplines. They concluded that further research would need to investigate the inter-
relationships between the four components of the turnaround process already
identified: the turnaround situation, the ‘retrenchment’ response, the ‘recovery’
response and the level of turnaround success achieved.
To guide potential empirical testing they developed a model of their theory of the
turnaround process, expressed as a series of interrelated phases associated with the
Turnaround Situation and Turnaround Response. They show the original causes of the
company’s performance downturn, divided into external and internal factors, which, if
not addressed, will eventually cause financial failure. The turnaround situation is
represented here by both absolute and relative-to-industry decline important enough to
trigger specific, targeted responses. The next stage of analysis allows an estimation of
the threat to be made, within the parameters of declining sales (low level threat) and
imminent bankruptcy (high level threat).
The Turnaround Response stage they divided into two distinct stages, specifying
respectively the measures necessary to ensure survival and/or achieve stability, and
then to achieve a long-term recovery.
Where the severity of the situation is limited, and a company has some financial
reserves, it might turn the situation around simply by following policies of
‘retrenchment’, cost-reduction through improving operational efficiency. However,
where risks are high and imminent, the model indicates that a further, more drastic
option is also required; a strategy of asset reduction, consolidating operations by
divesting the organization of its least productive parts, so gaining essential finance
whilst further improving efficiency. As has been noted from other studies, the
decision to be made must also be based on the causes of the original decline. This
involves assessment of the relative significance of operational inefficiency and
strategic misalignment.
Once immediate stability has been achieved, Robbins and Pearce’s (1992, 1993)
model suggests a second stage that of longer-term recovery, further addressing the
causes of decline, but reversing rather than simply halting the process.
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It may be that a company decides, if internal problems have been the major cause of
the turnaround situation, to continue its previous strategies, but with reduced resource
commitments. However, in most cases the essential work of continuing to maintain or
improve efficiency will be coupled with a gradual more towards a more dynamic
approach. As the model indicates, particularly if external factors were the more
dominant causes of decline, entrepreneurial reconfiguration strategies such as
developing new products or markets, acquisitions etc. will be more appropriate.
The completion of the turnaround process is represented by the achievement of
specific economic measures which indicate that the company had at least regained its
original levels of performance before the onset of decline. Robbins and Pearce (1992,
1993) also then addressed a number of problems perceived to be impeding further
progress in turnaround research, notably the absence of consistent definitions and
terminology. Smith and Gunalan (1996) and Smith and Graves (2005) illustrate the
lack of consensus between researchers as to exactly what constitutes a ‘turnaround
situation’ or ‘turnaround success’, with there being almost as many definitions as
researchers, varying in time span from 2 to 4 years of decline for the former and 2 to 6
years of improvement for the latter; a wide variety of financial measures or
‘thresholds’ for entry into either phase had also been suggested. One specific problem
for companies in highly cyclical industries is that they might have actually faced and
overcome turnaround situations within each cycle of the economy, while still
remaining market leaders in their industry even in the ‘down’ periods. It might
therefore be wise to adopt industry-based definitions, as suggested by Hambrick and
Schecter (1983), Ramanujam and Grant (1989) and Robbins and Pearce (1992, 1993).
A Refined Two-Stage Model
In their 1995 research Arogyaswamy, Barker and Yasai-Ardekani developed a model
that represented turnaround companies as showing two groups of responses to
decline; those strategies aiming to halt or reverse the adverse results of poor
performance and those strategies aiming at recovery by achieving a better competitive
position. They also suggested that both of these strategy sets were essential to
recovery, and that all strategies had to be effectively managed and adequately
supported. This necessarily included successful management of the company’s
external stakeholders together with its internal climate (specifically information flows
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and decision-making processes). They viewed the current literature as placing too
much emphasis on the role of ‘retrenchment’ as an immediate response, to the
detriment of alternatives.
A substantial literature tests the value of retrenching (defined as asset and cost
reduction) to turnaround. However, this has not yet succeeded in establishing a strong
positive empirical link between retrenchment and successful turnaround. The financial
ratios used measure significantly lower cost of goods sold/sales (e.g., Ramanujam
1984; Schendel & Patton 1976), lower inventory/sales and lower receivables/sales
(e.g., Hambrick & Schecter 1983; Ramanujam 1984), lower marketing
expenditure/sales, lower R&D expenditure/sales and increased sales per employee
(e.g., Hambrick & Schecter 1983) in successful turnaround companies. However, use
of these ratios means that the improvements can also be caused by greater sales gains.
The existing evidence does not therefore make explicit whether increased efficiency is
a result of asset or cost reduction, of sales gain, or of a combination of the two.
Hence there would appear to be more to the early stages of the turnaround process,
and that further investigation is necessary. Certainly there is already some evidence
that other problems existed in declining firms. For example Gilson (1990) and Sutton
(1990) found reduced or withdrawn support by external stakeholders, whilst
Mohrman and Mohrman (1983), Krantz (1985), Cameron, Whetten and Kim (1987)
demonstrated difficulties in the internal corporate climate, and Bozeman and Slusher
(1979), Staw, Sandelands and Dutton (1981) and D’Aunno and Sutton (1992) noted
links with poor decision-making processes. Cost and asset reduction alone are
unlikely to cure all of these problems. Therefore retrenchment as the sole initial
response is likely to be a necessary, but not a sufficient initiator of turnaround. Barker
and Mone (1994) argue that exclusive focus on retrenchment activities may obscure
or even exacerbate other problems and actually reduce chances of recovery; cost or
asset cutting strategies may reduce company morale to the extent of losing quality
employees, even from management level.
It is therefore important that models of the turnaround process recognize and address
the intricacies of the many factors involved, that they are often interdependent and
that strategies to address them may need to be simultaneous or overlapping. A major
design fault in many studies has also been the assumption that the stages in responses
are, or should be, linear in occurrence, whereas in reality the relationships between
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strategies are likely to be complex. To be more useful, models should therefore allow
for overlapping, feedback loops, and the impacts of one strategy on another.
Yet, by 1990 no large-sample study had produced evidence of the effectiveness of any
turnaround strategies other than those to do with increasing efficiency. Arogyaswamy
et al.(1995) suggested that this might be due to lack of examination of the
interdependence of the causes of, and response to, decline. Current study design had
meant that very heterogeneous samples were used, chosen regardless of the causes of
the decline of the companies involved. These might have been widely divergent and
might therefore have indicated very widely varying needs for strategic change. As a
result, they emphasised the need for recognition in model and research design of the
importance of the cause/causes of a company’s decline.
Another so far unaddressed issue was the role of management in the turnaround
process, particularly at top level. Although this had been frequently mentioned, there
was so far little empirical evidence from large sample studies that changes in top
management are linked to recovery (e.g., Lubatkin & Chung 1985; Castrogiovanni,
Baliga & Kidwell 1992). This may be either because management replacement is not
an effective response, or because ways have not been found to measure potential
results. The revised Arogyaswamy et al. (1995) model aimed to describe how
declining companies recovered, restricting its application to low diversity companies,
i.e. those that could only reverse decline through their existing operations. This
suggested specific strategies that might be adopted in the turnaround process:
3. Decline-Stemming Strategies
A number of authors (e.g., Slatter 1984; Smith & Graves 2005) highlight poor
adaptation to the environment, an increase in hostile circumstances, or a combination
of both as predictors of performance decline. If unchecked, this leads in turn to
erosion of external financial sources, a growth in internal problems and inefficiencies
and declining internal company climate, information flows and decision processes,
and eventual exhaustion of financial resources and outside support.
This downward spiral may be halted or reversed by the uptake of decline-stemming
strategies to create efficiency, stabilize the company’s internal environment and
renew external confidence and hence stakeholder support. Through feedback these
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strategies will take into consideration the severity of the situation, the level of
available resources, and the resource needs of future strategies.
Arogyaswamy et al. (1995) identified three related consequences of decline:
a) self-interest will lead stakeholders to either withdraw, reduce their commitment or
re-negotiate higher interest rates, so decreasing company revenues, or increasing
costs, which will threaten flexibility at the very time it is most needed. Customers
may be lost if there is a fear that quality or delivery may be compromised, whereas
suppliers may also withdraw, increase costs or reduce flexibility by demanding rigid
terms such as cash-on-delivery etc. Hence damage to relationships with stakeholders
can lead to a hard-to-reverse downward spiral of further performance reduction.
‘Slack’ financial resources and the support of creditors can therefore be a critical,
factor if successful turnaround is to be achieved.
b) inefficiency can be a consequence of decline as well as a cause; as an industry
contracts or competitors win over customers, demand may fall, so a company’s fixed
cost and asset base become under-utilized, even further restricting ability to compete
on price.
c) a matching deterioration in the company’s internal ‘climate’, is likely. Here decline
is characterized by a marked increase in levels of conflict, which may occur between
individuals, between groups or even departments as responsibility and blame are
dodged, and aggression rises. D’Aunno and Sutton (1992) highlight the consequent
downward spiral of inefficiency and time and wasted energy; Bozeman and Slusher
(1979), and Cameron et al.(1987) also noted the associated low worker morale and
lack of belief in the company itself, which will tend to increase inefficiency and
decrease input and energy levels; simultaneously, they found that there is a growing
tendency to form self-protective cliques or alliances, jockeying for perceived power at
many levels and increasing resistance to change of any sort.
These factors, and the threat of job losses through cost-cutting, may combine to
increase the exit of employees, and those most likely to go may be of the highest
quality, with valuable, intangible skills or equally valuable company-specific and
possibly undocumented or irreplaceable experience and knowledge about routines,
processes or products (e.g., Hirschman 1970, Greenhalgh 1983 and Perry 1986). At
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the same time, a failing company is unlikely to be able to attract new personnel of a
sufficiently high standard; lines of communication are likely to be adversely affected.
Problems to do with management may also increase. Bozeman and Slusher (1979),
Mohrman and Mohrman (1983) and Krantz (1985) all found evidence of a link
between decline in morale and a growth of negative, critical attitudes. This often
resulted in a loss of belief in the abilities of company leaders at many levels,
producing further inefficiencies, time-wasting, lack of direction and possibly even
‘under-mining’ activities.
The lack of trust may in certain circumstances be justified, as studies by both Whetten
(1980) and Staw et al.(1981) suggested that managers of failing companies face
increased stress and, as a result, become more erratic in their judgements and
decision-making, a common reaction to anxiety. The latter study echoed the findings
of Burns and Stalker (1961) and Sutton and D’Aunno (1989) in concluding that
stressed managers were decreasingly able to demonstrate flexibility or adaptability to
change. This loss of confidence can be a two-way process. Several of the above
researchers also noted a marked increase in over-centralised authority and decision-
making in failing companies, as stressed management reacted by trying to maintain or
extend their power base and showed lack of trust in their subordinates or colleagues.
Attempts to achieve successful turnaround must address all of these probable
consequences, and realize also that they may have some reciprocal causality. Decline-
stemming strategies targeting improvements in one area may yield improvements in
another:
Stakeholder Support
Slatter (1984), Hambrick (1985) and Slatter and Lovett (1999) suggested that specific
strategies for maintaining, renewing or even increasing stakeholder support are
important to successful turnaround. These may involve manipulative, substantive or
even purely symbolic actions to increase stakeholders’ perception of their power and
participation in the company’s activities, to highlight or clarify the benefits rather than
the potential costs of continued commitment and improve their general
perception/concept of the company and its credibility. Past research (e.g., Chaffee
1984, Rosenblatt, Rogers & Nord 1993, Rosenblatt and Mannheim 1996) has shown
18
that such redefinition is possible. It is has also shown that failure to do so produces
the ultimate risk of powerful stakeholders actually taking over control of a company
that they perceive as being in severe decline, to protect their own interests (e.g.,
Gopinath 1991).
Effects of Capital Structure
Ofek (1993) aimed to analyse differing company responses to short-term distress,
looking for ways to speed up company reactions and so preserve value. This
concentrated on the relationship between capital structure and company response,
building on Jensen’s (1989) work which concluded that highly-leveraged companies
will respond more quickly to a decline in company value than their less-leveraged
equivalents, because even a small decline in value might, for them, lead to default.
The implication here is that lower-leveraged companies, less likely to react to short-
term operational distress, will lose more of their going-concern value before taking
action.
Several other theoretical models had investigated the relationship between a poorly-
performing company’s capital structure (as characterized by its debt-to-equity ratio
plus managerial holdings) and its reactions to distress. These fall into two groups,
according to whether or not the actions taken generated cash. Some models (e.g.,
Harris and Raviv 1990) predicted a positive relationship between leverage and actions
that resulted in short-term cash flow, the implication being that the obligation to
service debts required sale of assets and operations divestment.
Leverage has an effect on the probability of debt restructuring or bankruptcy, but
overall capital structure will likely determine which of the two is chosen. Jensen
(1989) argues that highly leveraged companies are more likely to restructure their
debt as their company value falls, particularly if the going-concern value is
significantly greater than potential liquidation value. Conversely, as increased
leverage results in going-concern value nearing liquidation value, bankruptcy
becomes more likely. Some ‘cut-off point’ here may be reflected in turnaround
selection.
Another common financial response to distress is that of cutting dividends (which will
affect both the value of various claims and the cash flow distribution to the company’s
owners). DeAngelo and DeAngelo (1990), for example, concluded that 67% of
19
companies that experienced decline over at least three years, cut dividends in the first
year of distress, which may be taken as an alarm signal. Ofek (1993) found that
private debt had a stronger effect on a company’s actions than public debt, supporting
the findings of Gilson et al.(1990) who had concluded that companies with a high
ratio of bank debt were more likely to successfully restructure their debt.
Ofek (1993) also reported that, whereas managerial holdings had no effect on cash-
generating restructuring, there was a negative relation between managerial holdings
and operational actions with no immediate cash flow effects, implying that they avoid
taking actions such as closing plants, discontinuing operations, laying-off employees
or replacing other executive officers. This may be due to inertia or psychological self-
interest as much as financial self-interest, but it highlights the fact that larger
managerial holdings may actually discourage value-maximizing decisions; another
important point for consideration in turnaround selection.
One surprising result was that, not only did the size of outside stockholding not
significantly increase the probability of operational action, but that the existence of a
large non-managerial investor even reduced the probability of such action. To
discover whether this was true of all of investors, Ofek (1993) tested seven different
types, and found that only investment management firms had any positive impact on
the probability of general operational action, or even individual actions. So, overall, a
company’s reactions to distress can be said to be largely unrelated to the type of
outside stockholder, possibly because even large non-managerial stockholders cannot
control company actions. Ofek’s (1993) findings were largely consistent with those of
Jensen (1989): highly-leveraged companies are more likely to react to distress with
operational and financial change than their less-leveraged equivalents and this
reaction is also more rapid. The implication is that the choice of high leverage by a
company during ‘normal’ operations actually provides a certain discipline so that the
existence of debt may help to preserve the firm’s going-concern value, and may be a
positive indicator of potential success in turnaround.
Bibeault (1982) characterized success by high energy (supporting research) and
intense anticipatory policies aimed at restating ‘fit’ to changing markets by
repositioning, through decreasing activities rather than expanding, plus many
mutually coherent internal adjustments and decentralization. Schreuder (1993) sought
to provide empirical support through a study of companies selected from industry
20
sectors suffering from lengthy and serious problems. ‘Successful’ companies
maintained fairly stable development over the first five years, followed by increasing
profitability in the next three; of the ‘less successful’ 90% reported reduced profit
levels in the first five years, with almost one third going bankrupt or being taken over,
and none regained their initial profit levels within the study period.
Schreuder (1993) compared the number, areas and timing of measures taken by the
two groups in response to the crises in their industries, finding that the successful
companies took more measures overall, with altered market strategies and product
ranges, only 60% and 80% respectively of the unsuccessful groups did likewise. The
less successful companies were much more active in taking cost cutting measures.
Schreuder (1993) noted that about 30% of both groups replaced their top
management, but, that at the same time successful companies tended to expand
middle management, while the less successful cut back. As a result the successful
group combined intensely market-orientated policies with decentralization and
decreasing their range of activities, whilst the less successful matched cost-orientated
policies with centralization and diversification more outside their industry.
Timing was also found to be a crucial factor; successful companies took their
measures in management, market and production on average one year before the start
of the industry crisis, apparently anticipating problems. Less successful companies
were characterized by a lag in response to deteriorating conditions, with measures
being taken to adjust organization and management, on average, a full two years after
the onset of crisis. Thus successful companies were characterized by changing top
management and empowering middle management at the start of their series of
measures, whilst less successful companies did so at the end, perhaps when all other
possibilities had been exhausted.
At the same time specific effective strategies to stabilize the company’s internal
climate and decision processes should be implemented. Hedberg, Nystrom and
Starbuck (1976), Cameron (1983), and Mohrman and Mohrman (1983), among
others, advocate a corporate culture emphasizing, encouraging and supporting
participation, decentralization, flexibility, experimentation and ease of
communication. Sutton, Eisenhardt and Jucker (1986) also suggest that the important
problem of loss of talented employees, wishing to avoid the stigma of association with
21
decline, be addressed through human resource strategies which motivate remaining
employees.

4. Management Ability to Implement Decline-Stemming Strategies
Several studies (e.g., Hofer 1980; Robbins & Pearce 1992) have suggested that the
severity of decline largely determines the choice of strategy, between asset or cost
reduction, and also the extent and rigour with which associated measures will be
applied.
Lohrke, Bedeian and Palmer (2004) suggest that the level of resource ‘slack’ will be
another important influence on corporate response. Hambrick and D’Aveni (1988)
suggest that, if this is limited, the company will be more vulnerable. Thus while a
company might be expected to initiate vigorous decline-stemming strategies, their
implementation and flexibility may be constrained by lack of finance. A large amount
of available slack, conversely, may dull perception of, or actually reduce the need for,
uptake of decline-stemming strategies, since the spare capacity will allow a certain
level of performance variability to be absorbed.
Many researchers (e.g., Grinyer & Spender 1979, Hofer 1980, Bibeault 1982,
Nystrom & Starbuck 1984, Slatter 1984 and Slatter & Lovett 1999) have observed
that in declining companies the turnaround process will usually be initiated by the
removal of top managers, or even the CEO. However, Frederickson, Hambrick and
Baumrin (1988) observe that where company decline is perceived to be attributable to
uncontrollable external causes such as political events, specific industry decline or
economic recession, then retention of the CEO might retain some corporate
credibility. Thus, where the causes of decline are industry-contraction-based, changes
in top management may actually be counter productive, particularly (e.g., Friedman
and Saul 1991) where such changes can be distractingly disruptive.
Where stakeholders regard the incumbent CEO as responsible for the decline, they
may be treated as scapegoats. Where such action does not address other possible
causes of decline it may contribute to lower employee morale, accentuating internal
dysfunction and withdrawal of stakeholder resources, and increasing the risk of
22
failure. Barker, Patterson and Mueller (2001) suggest that replacements, particularly if
imported, are likely to have fresh perceptions and new perspectives based on differing
experiences and knowledge; Kow (2004) and Clapham, Schwenk and Caldwell (2005)
support replacement of the CEO asmore likely to promote a turnaround. Friedman and
Singh (1989), and Worrell, Davidson and Glascock (1993) observe that replacement
of the CEO with an outsider has produced rises in company stock prices, but there is
considerable disagreement in the results of empirical studies on stock-market
reactions to changes in senior management, with Bonnier and Bruner (1989), Khanna
and Poulsen (1995), Warner, Watts and Wruck (1988), and Weisbach (1988)
reaching opposing conclusions.
5. Causes of Decline and Loss of Competitive Position
Strategic reorientation will vary in direction and depth according to the causes of the
company’s loss of performance. Whetten (1987) and Cameron, Sutton and Whetten
(1988) note that decline can be caused by either industry-wide contraction (where the
market cannot support the original number of companies and intense competition
causes deteriorating performance) or by underperformance in an expanding or stable
industry. A variety of reasons for the latter have been suggested:
(i) unanticipated changes in the factors providing competitive advantage (e.g., the
introduction of new products or services by competitors) as noted by Barney (1991);
(ii) the loss of firm specific skills (human capital) which were the foundation of the
firm’s competitive advantage, as noted by Castanias and Helfat (2001);
(iii) the adoption of misplaced strategies, or failure to update its traditional
capabilities, experience, knowledge or resources, as noted by Grinyer and Spender
(1979).
Hefer (1980), O’Neill (1986) and Thietart (1988) all emphasise the importance of a
company’s market share in the choice and effectiveness of its recovery strategies. If
performance decline is due to short-or even long-term contraction of the whole
industry, the company may actually still be in a good position relative to others.
Conversely, firm-based decline usually indicates a poor market position, although this
may mask potentially valuable capabilities or resources that are simply being under
23
utilized. These findings highlight the importance of matching turnaround strategies to
the cause of decline.
Arogyaswamy, Barker III and Yasai-Ardekani (1995) suggested that where decline
could be attributed to a short-term, cyclical contraction, recovery strategies that did
not make major changes to its strategic orientation would be the most effective. This
extends the work of Hannah and Freeman (1984) and O’Neill (1986); Hannah and
Freeman (1984) note that reorientations involving new routines, skills or even
structures and reorganization entail considerable cost, which are particularly difficult
to absorb in times of increased competition, and may actually produce a greater risk
of failure; O’Neill (1986) suggested that this situation should be met by small-scale
and gradual strategy changes with the objective of further reducing costs, while
maintaining and strengthening the existing market advantages.
For long-lasting industry contraction Harrigan (1980), for example, recommends that
companies in a good position should adapt incremental strategy changes that expand
or hold this position by further investment to exploit or strengthen already existing
resources and capabilities, hopefully ‘freezing out’ weaker competitors or forcing
them to specialize in small customer segments. Harrigan (1980) (1985) suggests that
already weakly positioned companies should adopt this ‘niching’ strategy anyway.
For firm-based declining companies, many researchers (e.g., Schendel et al. 1976,
Grinyer & Spender 1979, Hofer 1980, O’Neill 1986 and Arogyaswamy et al. 1995)
agree that strategic reorientation and fundamental changes in strategy and structure
are needed to produce resources and capabilities better fitted to the needs of the
environment. Where such decline-stemming strategies are implemented too late and
with insufficient strength, then failure is likely to follow. Hedberg and Jonsson
(1977), Starbuck et al (1978) and Ford (1985) all suggest that this may be largely due
to managers failing to differentiate between company-based causes and temporary-
industry-contraction causes, preferring to choose the latter and so failing to react.
Even if the causes of decline are industry-based, managers may fail to recognize when
the hostile external situation extends in duration or becomes permanent rather than a
temporary phase that requires little or no adaptation.
This misdiagnosis may be due to a lack of willingness on the part of managers to
accept responsibility for failure, particularly if they have previously been successful.
Hedberg and Jonsson (1977), Nystrom and Starbuck (1984), and Barr, Stempert and
24
Huff (1992) observe that managers may block their perceptions of new problems or
situations, resulting in problem-solving methods being adopted, which are no longer
appropriate. Yet even if correct diagnosis of cause occurs, Tushman and Romomelli
(1985) show how both individuals within an organization and influential stakeholders
may block moves that they perceive as threatening their resources or power.
Further Refinement of Turnaround Models
Sudarsanam and Lai (2001) summarized the current research on corporate turnaround
from financial distress, and compared the practical applicability and effectiveness of
the more important proposed turnaround strategies on a large sample of 166
potentially bankrupt companies (1985-1993). This focussed on the relative
significance of the timing, intensity and form of implementation of the various
suggested procedures, tracking their success over a 3-year period from distress.
Sudarsanam and Lai examined restructuring responses, categorized as managerial,
asset or strategic, financial, operational or organizational, and inappropriate response,
embracing managerial inaction or poor choice of strategy, poor timing, lack of focus
and concentration or intensity and/or poor implementation of chosen turnaround
strategies. They tested empirically the effectiveness of each restructuring strategy, as
well as the overall effectiveness of a combination of identified strategies, and
concluded that an assessment of financial restructuring, as a key element of corporate
restructuring, was important. This might involve examining dividend cuts or
omissions (often the choice of larger firms) and equity issues, or the replacement of
existing debts with new contracts (reducing interest or capital, extending maturity or a
debt-equity exchange); in other words equity and/or debt-based strategies.
However, they were still of the opinion that the adoption of turnaround strategies
alone could be no guarantee of recovery. Even though strategies might be
simultaneous, sequentially or overlapping in application, affecting turnaround to a
different extent, or depending for their influence on each other, both recovery and
non-recovery companies actually adapted very similar sets of strategies immediately
after financial distress, though their choices differed as time went on. Recovery
companies tended towards investment and acquisition, whereas non-recovery
companies were more inward-looking, concentrating on financial and operational
restructuring. However, evidence suggested that actual choice of strategy was not as
25
important as the effectiveness of the strategy chosen, which depended on speed,
intensity and competence.

6. Conclusions and Research Agenda
Much of the above literature has agreed that top management change is a precondition
for successful turnarounds, particularly to establish bank and creditor confidence in
the ability of the company to manage the crisis and to re-motivate employees. This is
likely to be so even if the cause of poor performance is beyond management control,
since as Grinyer, Mayes and McKiernan (1988) note, one of the major differences,
between recovering and non-recovering firms is that the former make more
management changes.
The effectiveness of managerial restructuring in turnaround may therefore be an
avenue for further research.
Several factors determine choice of strategy: the company’s capital structure
necessitates consideration of its relationship with its bank, and the influence and
desires of block shareholders and managerial shareholders; the company’s leverage
position, as detailed by John, Lang and Netter (1992), Ofek (1993) and Kang and
Shivdasani (1997), is clearly critical to the suceess of any restructuring. Although
many distressed companies make it a priority to reduce borrowings and interest costs,
financial restructuring had not been identified as a necessary component of
turnaround strategy until relatively recently, notably following Grinyer, Mayes and
McKiernan (1988).
The literature provides some support for an overlapping, two-stage approach to
turnaround strategy, which can be categorized as the i) operating/efficiency
turnaround stage, and the ii) entrepreneurial/ strategic stage, where the latter eludes
the non-recovering firms. The former aims to stabilize operations, the latter seeks to
restore profitability, where both address cost reduction, revenue generation and
operation-asset reduction programmes to cut down direct costs and overheads whilst
maintaining or improving production.
26
Depending on the severity of the distress, divestment of subsidiaries or divisions may
even be imperative. Non-profit generating assets must go to stop the cash drain, and
even profitable assets may have to be converted into cash. This is the most common
turnaround strategy for all but the smallest companies; even so, Sudarsanam and Lai
(2001) suggest that further empirical research is required to assess its significance in
achieving successful turnaround.
An examination of asset investment might include both internal capital expenditure
(designed to improve productivity and reduce costs) and acquisitions (where
companies have mature or declining markets or products). Both might enhance the
company’s competitive advantage, but can only be undertaken after very careful
planning, and when the extremity of financial distress has been overcome or before it
occurs. One danger is that acquisitions might be undertaken to promote apparent
growth, but without being sustainable. Pearce and Robbins (1993) suggest the need
for further work in this area.
A number of researchers (e.g., Robbins & Pearce 1992, Barker & Mone 1994 and
Hoffman 1989) have suggested that how managers tackle the company’s problems
could be just as, or even more important than, whether they take action at all,
indicating that turnaround success or failure depends more on strategy implementation
than on strategy choice. This issue also requires further empirical investigation.

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