Why Businesses Fail

To understand why businesses fail we need to recognise two complementary truths:

What happens when a business fails, in simple terms, is that it runs out of cash: insolvency is essentially a matter of being unable to pay bills when they fall due. Businesses can run out of cash for a variety of reasons:

• Lack of profit – the available cash has been drained away by losses caused by a failure to maintain an appropriate ‘recipe’.
• Excess illiquid assets – the business has tied up too much of its cash in plant and machinery, property, slow-moving stock, or the development of a new product and thus has insufficient left to fund its trading (see the discussion of the working capital cycle in Chapter 6).
• Too much growth – the business’s transactions are expanding faster than the cash resources needed to fund them (i.e. it is ‘overtrading’).

 

All businesses, therefore, need to manage cash as one of their primary functions. However, problems with either this function and/or the business’s recipe will lead to failure in the long term.

The Types Of Business Failure

Business failures generally fall into one of three classic types.

1. The Start Up That Never Starts

Statistics show that the majority of businesses cease trading within the first three years. Some of these, however, are not strictly failures but represent the individuals who started up the businesses returning to paid employment. Some of the commonest causes of such failures include the following:

• The business model is wrong: the anticipated market does not, in fact, exist.
• The business is undercapitalised: it runs out of cash when trying to establish itself and to prove its market.
• The business survives this former stage but hasn’t become sufficiently established with enough reserves; it fails to weather a downturn a longer-established business would survive.
• The business has been set up in a high-growth industry but fails to survive the ‘shake out’. This is a particularly common phenomenon in new or suddenly fashionable sectors (e.g. skateboard shops in the 1970s). In such situations many new players enter an expanding market to cash in on the perceived easy profits, only to find that the sector’s initial growth slows or even reverses, leaving the rush of entrants with overcapacity and facing a slowing or falling demand. How many mobile phone shops are there on your high street today? How many do you think there will be in five years’ time?
• The business person has the wrong personality type or lacks the determination to see the business through. For example, he or she is is unable or unwilling to face up to necessary business tasks, such as cold calling for sales.

2. The Catastrophic Failure

These types of business failure are surprisingly rare. Such failures are where the business fails to survive some sort of traumatic event, such as those listed below. The effects of each type of event can, in most cases, be significantly reduced by good management:

• A major fire or flood may be regarded as an uncontrollable ‘act of God’, but businesses should take some steps to plan for such eventualities by way of insurance cover and sensible contingency planning.
• Major fraud can be catastrophic. Therefore the management of any business should take responsibility for setting up controls to ensure this does not happen. Many frauds start in a small way and grow hugely over time, but they can be detected by the application of simple controls and procedures.
• Occasionally a governmental act can be catastrophic since legislative changes can prevent businesses from operating almost overnight (e.g. legislation to control gun clubs). More often, however, legislation changes the rules by which businesses have to operate. For example, in the 1990s the UK government changed the rules about payments made by local authorities for nursing home services. While such changes can be quite swift, the nature of the political process usually allows some warning. It is also true to say that, in the example just given, not all nursing homes were forced out of business and that it was the good-quality, well managed and well run nursing homes that were best positioned to survive the changes in legislation.
• Major litigation, for example, over an alleged patent infringement, can also sink a company. However, it is up to management to have the foresight to deal with this sort of commercial risk.

 

Overtrading failures, particularly in high growth companies, may often ‘feel like’ catastrophic failures since they may seem to appear quite suddenly. However in retrospect the symptoms of increasing cash pressures are often there if you look.