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Business Failures of The Fourth Kind

It is a blunt fact that every day, businesses fail.

In fact to be more accurate, in a normal year on average around 50 companies go into liquidation on every business day of the year. During a recession such as in 1992 that figure went up to over 90. And that’s just the companies. It doesn’t include the sole traders and partnerships that go under as well.

So why do businesses fail?

Business failures are a bit like fires. Something smouldering may be difficult to see but can be relatively easy to put out with little damage or risk if caught early. Once a fire is really going, it is much easier to see, but is usually much more difficult and dangerous to extinguish as it consumes resources, and crucially, cash.

As the old saying has it, cash is king. And no one believes this more firmly than turnaround professionals. Because fundamentally businesses fail when they run out of cash.

And while there are well established ways of tackling businesses that are starting to burn their cash, one of the major problems for turnaround professionals is that we are often called in too late.

If you see a burning house you would call the fire brigade. If you see a business that is fire fighting, it is time to call in the business fire brigade, a company doctor.

What causes business failure?

There are really four types of business failure.

Firstly there is the start up that never does. It’s a well known statistic that most businesses cease trading within their first three years. In many ways this is an inevitable result of the willingness of entrepreneurs to take the risk of starting up and testing the market.

Given how difficult it can be to raise money in the UK for a new venture, many such businesses have so few resources to start out with that a relatively small set back in the early years can be sufficient to wipe them out, where a larger business would pull through. Having got through these critical first three years however, business failures then fall into three main camps.

Catastrophic business failures where the business suddenly ‘falls off a cliff’ are the second type of failure. While often being high profile, these are actually quite rare and are often due to the impact of some traumatic event such as a major fraud, lost litigation or sudden change in the law.

The third type of failure, overtrading, by contrast is a relatively common cause of business failure in boom times as businesses grow faster than their cash resources can support.

But most failures are of the fourth type and follow what has come to be known as the business decline curve where a business that is underperforming, starts to become distressed and as the decline steepens, falls into crisis and eventual failure.

How do you spot the warning signs?

One particularly frightening thing about the decline curve is how as a business descends the slippery slope, problems start to compound.

The underperforming business is making less profits than its competitors. With less profits it can reinvest less into the business. Slowly, insidiously, it starts to slip behind and over time market reputation and share are lost, resulting eventually in the first losses being recorded.

As it has to fund losses, a business in distress starts to stretch and juggle its cash. The bank manager wants security and personal guarantees as the account starts to be constantly up against the overdraft limit, and the business starts to delay sending in management accounts; the business starts to stretch payments to suppliers and subcontractors or make round sum payments on account as a way of eking out the available cash. The staff know that the business has problems and morale and quality of work sinks.

By the time it is in a crisis the finance director has either jumped ship or has gone off on long term sick leave. It is on stop with its suppliers and the CCJs are starting to fly. So sub-contractors are stopping work and the business cannot get the materials needed to complete its contracts or products and so collect in cash from its customers.

And if it cannot get the cash in to pay the rent or the wages at the end of the month, suddenly it’s all over.

What causes normal business failure?

So how do businesses get themselves into these sorts of situations?

There seem to be five main contributing factors to most ‘normal’ business failures in varying degrees.

First and foremost there are management problems. The autocratic managing director whose drive has been vital in the past, but is now driving the business into the ground while simultaneously driving away anyone who tries to disagree; the board dispute that has led to civil war; the lack of anyone who really understands what the numbers are telling them; the family company run in the interests of family members and not the business’s needs. Any and all of these sorts of issues can prevent the business recognising or dealing with the problems facing it.

Because secondly, any business needs to have an eye out for the strategy challenges that it will inevitably face, whether these are changes in the market and customers demands; technological changes that require reinvesting and moving on; or changes in the competition which require improved efficiencies to keep the cost base competitive.

The third area is a lack of financial control, where it is usual to find that cash has become tied up in old stock, debt or retentions; that lack of proper reporting means costs are actually out of control (is all that machinery we are paying hire charges for really still on site?), management do not have accurate costings so they do not really know how much margin each job is making, and there is weak control of variations and valuations so the eventual outcome is uncertain.

Fourthly there is a lack of operational control of both hard issues such as up to date machinery; and the soft issues of organisational structure and staff management.

Finally there are any ‘big project’ such as a new computer system, a problem acquisition, a huge new contract, or a premises move. Anything that adds extra disruption to the business, while taking away cash and management time can prove to be the straw that breaks the camel’s back.

So if you start to recognise any of these signs, seek professional advice from an accredited turnaround professional with experience in dealing with these types of situations.