Businesses can fail. It is a normal part of the business life cycle and in times of crisis it is an everyday occurrence.  Understandably, nobody wants that to happen to their own business.  To avoid it from happening, we must first understand why businesses fail.

When a business fails, it happens because it ran out of cash. In technical terms – it became insolvent. Businesses basically run out of cash for a variety of reasons:

-          Lack of profit – the available cash was not enough to cover the losses caused by inadequate business performance.

-          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.

-          Too much growth – the business’s transactions are expanding faster that the cash resources needed to fund them.

All businesses 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

Generally, business failures can be divided into three types.

1.       The business that never starts

Statistics show that a large proportion of new businesses does fail within the first couple of years. However, some among them are not strictly failures, but individuals who started them returned to paid employment. Some of the more common causes are:

o   The business model is wrong – the anticipated market does not exist.

o   The business is undercapitalized: it runs out of cash when trying to establish itself and to prove its market.

o   The business survives the early stages of formation, but it hasn’t become sufficiently established with enough reserves. In other words, it cannot function in times of lower economic activity.

o   The business has been set up in a high-growth industry, but it doesn’t survive the burst of “the bubble”.  It is a common phenomenon in new or suddenly popular sectors. Businesses enter the market expecting easy profits, but they find that the initial growth slows or even reverses and leaves them facing a slowing demand.

o   The business person doesn’t have the necessary skills or the drive to see the business through.

2.       The catastrophic failure

These types of business failure are surprisingly rare. They are traumatic events whose effect can be significantly reduced by good management and include:

o   A major fire or flood – These kinds of catastrophes may be regarded as the “act of God”, but the consequences can be lessened or even avoided by using insurance cover and contingency planning.

o   Major fraud – Potentially catastrophic. The management should take steps to insure this does not happen. Simple controls and procedures can minimize the risk and the potential damage caused by such events.

o   Government act – Sometimes governments make legislative changes that can prevent a business form operating overnight. More often, the governments change the rules by which business is done. Although some notice is usually given, these changes come faster than some businesses can adapt. In this case only the well managed and well run businesses will be able to survive.

o   Major litigation – For example, litigation over an alleged patent infringement can also be detrimental to a company. It is up to the management to have the foresight to deal with this sort of risk.

3.       Failure over time

This is also called the normal type of failure for an established business. The process starts with simple underperformance that results in poor profitability. Over time, continued underperformance translates into reduced reserves and investment, and the balance sheet starts to show signs of distress. Time and available resources start to run out. As the business begins to get into real difficulties the slope into crisis becomes steeper. The problems now start to compound each with the other. For example, you are on stop with your supplier so you can’t get the raw materials that would allow you to complete an order and so bill your client, but you cannot collect cash from your client until you have completed

the whole order. At the same time, interest charges, purchasing inefficiencies and late payment penalties increase costs and eat into your available cash.

THE SYMPTOMS OF NORMAL FAILURE

As a business slides down the decline curve, the symptoms of decline become more and more apparent in its accounts. The problems with accounts are, however, first, they are, by definition, backwards looking and are, therefore, always somewhat out of date (for example, if a company is only producing statutory accounts for filing, this information can be the best part of two years old by the time it has to be made public); and, secondly, there’s none so blind as those who will not see. Where the results are bad and/or there is weak financial reporting, accounts can be very out of date if people do not want to face up to seeing the reality, or let others (such as the bank) see the actual position. A deteriorating bank balance is bad enough but when this is combined with a delay in producing your accounts, the warning sirens really start to go off in your bank manager’s office!

However the signs can also readily be seen in non-financial indicators, and an overall guide to these symptoms is set out below. Unfortunately, this is one of those cases where the more uncomfortable reading this makes, the more you need help.

Underperformance

Underperformance means that:

• your market share and reputation are being lost;

• your turnover is stagnant or reducing;

• your profits are stagnant or declining and, sooner or later, the first losses are being reported; and

• the bank is taking security for its lending (if it doesn’t already have it) and is starting to demand more information from you.

Distress

When your business is in distress, the following situations may arise. First, you may find your staff turnover is rising and that your business needs to borrow heavily to fund trading (as a result of its reduced profits). Increased borrowing can lead to the following:

• Your bank overdraft rises. The bank sees a growing ‘hardcore’ of overdraft debt: your account fails to swing’ into credit.

• You start to stretch creditor payment terms as you start to rely on more and more creditor funding. This results in higher ‘creditor days’ and the aged creditor reports begin to show significant older values.

• You are forced to acquire assets on lease or hire purchase you would once have bought outright.

• Despite your dislike of it (because ‘it’s only something businesses in difficulty do’), you start to think about moving to factoring as a way of getting more lending against your debtors than your bank is giving you.

Secondly, you start to make regular or more severe losses until losses become the norm. You seem to have forgotten you are in business to make a profit and you consider breaking even to be ‘good news’. Your credit rating starts to fall as your reported financial performance worsens, and your accounts start to appear later and later. Your audit report is qualified. Next, your relationship with your bank becomes strained, as they start to require regular meetings, more information and projections, further personal guarantees and/or the introduction of an investigating accountant. Finally, you gamble. You put a disproportionate effort into long-shot big projects that will save your business if they come
off rather than facing up to the real here-and-now unpleasant actions you really need to take.

Crisis

When your business is in crisis, your finance director jumps ship or goes off on long-term sickness. Your overdraft is at or over the limit and your bank is bouncing cheques (or threatening to do so) and pressing for a reduction in its exposure. You are making ‘payments on account’ and/or are actively delaying payments to creditors in an attempt to manage the cash or to stave off failure. Suppliers are demanding payments to clear or reduce their accounts and are placing you on stop. Your statutory payments (PAYE, VAT) are in arrears. Legal action begins, starting with writs, county court judgments, statutory demands for payment and threats of petitions for winding up your business. The legal pressure increases, with the Inland Revenue and/or HM Customs & Excise sending in bailiffs to take walking possession over your assets. Winding-up petitions are presented. Letters from insolvency practitioners (IPs) and ‘debt counselors’ arrive, asking if they can help. IPs eager for a job notify your bank you are in trouble, basing their judgment on the legal actions that are being taken against you (which becomes a self-fulfilling prophecy). Your landlord distraints for unpaid rent.

The next step is failure and insolvency.

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