WHY BUSINESSES FAIL

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

• 1.All businesses are fundamentally the same. All businesses have to buy in and sell on goods and/or services to their customers, who will keep on buying if the offer provides value in satisfying their needs. All businesses must try to make a profit. They also need to manage their employees, sales, production, premises and cash and to collect in their debts, pay their suppliers, submit their tax returns and so on. All businesses therefore need to undertake the same functions.
• 2.All businesses are fundamentally different. Businesses comprise different people operating in different cultures that have different values, expectations and experiences. Businesses do things in different ways, sell different goods and/or services and offer different values to different customers with whom they have different relationships. They all have a unique ‘recipe’ for what they do and how they do it.

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.

3. Incremental failure over time

Incremental failure over time is the ‘normal’ type of failure for an established business.

NORMAL BUSINESS FAILURE

Normal business failure follows what is known as a ‘decline curve’ and is the result of an accelerating process rather than an individual catastrophic event (Figure 5).

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.

Allowing a business to reach this stage must be seen as evidence of weak management. Trying to manage a business in this state is obviously an unpleasant and increasingly difficult task, so no one wants to be in this situation if he or she does not have to be and certainly for no longer than is absolutely necessary. The fact you are in these circumstances indicates you are going to need some kind of outside help in order to change the direction of the curve and to save your business.

If the direction of the curve is not reversed, the business will eventually fail.

AVOIDING FAILURE

In general this book assumes that your business has got past its first three years and is suffering from a ‘normal’ type of decline. However, having said that, most of the advice in this book is also applicable to potential start-up and catastrophic failures.

To come up with a plan to address the risk of normal failure you need to take the following steps:

• 1.recognise the symptoms of normal failure;
• 2.check your business’s health to detect the warning signs;
• 3.recognise the causes of normal failure; and
• 4.judge how serious things are.

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. However, the problems with accounts are, 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 (or you may have no choice if your bank insists).

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 judgements, 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 counsellors’ arrive, asking if they can help. IPs eager for a job notify your bank you are in trouble, basing their judgement on the legal actions that are being taken against you (which becomes a self-fulfilling prophesy). Your landlord distrains for unpaid rent.

The next step is failure and insolvency.

CHECKING YOUR BUSINESS’S HEALTH TO SPOT THE WARNING SIGNS

In a real crisis the fire alarm should be sounding good and loud but, if things haven’t got to this stage, there are a number of tools and techniques you can use on a regular basis to help you judge whether you have a current or impending problem. These fall into two categories.

Subjective judgements and objective measures

Subjective judgements

Subjective judgements are, in the main, non-financial. They include such measures as the following:

• Assessing whether your business is suffering from any of the symptoms of normal failure as outlined above.
• Using the health check set out at the end of Chapter 1 or an ‘A’ score test (see the end of this chapter), which will also help you to look at the causes of your problems.
• Seeking an external opinion from such sources as your accountant or bank manager.

Objective measures

Objective measures of a business’s financial performance are based on statistical analyses, such as commercial credit rating information and ‘Z’ and ‘H’ scores.

Surprisingly, perhaps, subjective judgements often give a better long-term preventative warning of problems since they look at the forces that will eventually start to show through in poor financial results. Financially based measures, on the other hand, pick up on poor or declining performance that must already be showing up clearly in the trading figures and, for companies in difficulties, this sort of information can be seriously out of date.

To obtain most value from subjective tests, you should not only perform them yourself but should also use them to obtain others’ views. Get your managers to do them as well (preferably on an anonymous basis so you obtain an honest view) so that you can test your findings against theirs. Find an external adviser whom you trust and ask him or her to provide you with his or her views as well. This helps to avoid ‘group think’ where members of the management team (who are all sharing the same bunker) are unhealthily mirroring one particular view of the situation back to each other.

Identifying the causes of what is going wrong is the first step to fixing it.

Health check against symptoms and causes

Using the checklist given in Figure 6, tick all those symptoms of normal failure your company is displaying:

• Which categories do the ticked items fall into: under-performance, distress or crisis? Use your results to assess how far you have progressed down the decline curve.
• What areas of weakness has this exercise identified?

Once you have completed this exercise, it is worth asking yourself a further supplementary question: how surprising are your findings? If they do come as a surprise, why has this happened? Are you working in your business too much, rather than on it? If they do not come as a surprise, the exercise has simply told you things you already knew. If this is the case, are these things you:

• Are addressing actively?
• Had not thought to be serious?
• Have been avoiding or not facing up to?

Accountant/bank manager feedback

You work in one business but your accountant and your bank manager between them deal with hundreds of businesses. As we have seen, whilst all these businesses will be different they will all have the same functions and each will have developed a recipe that works with its type of industry, its clients, its products, staff and owners. If you seek out and listen to advice accountants and bank managers are able to give you, you will be tapping into a wealth of experience these people have gained through working with businesses that have been confronted with problems similar to your own. Do not, therefore, underestimate the long-term value of good professional advice. In addition, these people may be able to provide you with specific ‘benchmarking information’ that allows you to compare your performance across a variety of measures and against others in the same industry.

Remember also that your bank has access to what is usually a very telling indication of business health, and that is your bank account.

Example

Figure 7 shows Company B’s monthly maximum credit and overdrawn account balances in each month over the last two years. Now you might think a business that has been operating within its facility every month except the last (when it was marginally over) would be one the bank is quite relaxed about. However, even before the accounts for the last two years were published, the bank manager will be worried:

• The account’s ‘swing’ (the movement between its highest and lowest balance in a month) has narrowed dramatically as the company has struggled to keep within its overdraft limit by only issuing cheques against money as it comes in.
• The account is, however, no longer ‘swinging’ into credit.
• The account’s ‘headroom’ (the unused facility available) has been steadily decreasing and it is now recording its first ‘excess’ (the balance is over its agreed facility).
• A ‘hardcore’ of overdraft has been steadily building that is no longer cleared on a regular basis by the account swinging into credit.

In the absence of any other explanation, the bank manager’s assumption in these circumstances is that Company B’s hardcore overdraft represents the cash effects of sustained trading losses.

Plot this graph for your business. What does it suggest to you?

Please note that where banks prepare this sort of graph, they do so to measure their exposure to you. Their version will therefore have an inverted scale showing exposure climbing as the overdraft grows.

Credit scores

Credit-rating agencies earn some of their income through checking on the health of businesses so as to be able to advise other businesses on the levels of credit to extend. Widely available from a number of sources, these assessments will show you how independent external agencies have assessed your business’s financial health on the basis of your published accounts (e.g. some are on the basis of a score from 1-100). They can also be used to provide a snapshot of current, apparent financial health as well as of annual trends.

‘Z’ and ‘H’ scores

Z scores are statistical analyses of business failures that look back at statistics over periods of decades. Such analyses have resulted in the identification of a mix of different financial ratios that are characteristic indicators of failing businesses in various sectors. H scores calculate the same mix of ratios for your own business, compare these to the set for failed businesses and then produce a ‘health score’ based on how close to, or far from, this group your scores are. This health score is used as a statistical indicator of likely distress (and, by implication, failure) over the next three years.

TAKE AN ‘A’ SCORE TEST

An A score test uses non-financial signs in a structured way. It makes the assumption that business difficulties stem from problems with management organisation, controls, or the ability to change which, over time, lead to mistakes being made that in turn, lead to real signs and symptoms of difficulty.

To undertake this test, simply look through the statements set out below. If you disagree with a statement, cross out the relevant score; if you agree with it, leave the score as it is. Make each a positive ‘yes’ or ‘no’ decision: there are no part marks!

Management
The business is run by an autocrat	8
The chief executive and chairperson are the same individual	4
The other directors are non-existent, passive or noncontributing	2
Your business lacks directors with all-round skills	2
There is a specific lack of a strong finance director	2
Your business lacks management depth below board level	1
	19
Accounting controls
There are no budgetary control, budgets or variance reports	3
There are no up-to-date cashflow plans and no or poor knowledge of borrowing requirements	3
Your business has no costing system so that managers do not have accurate information about costs/contributions	3
	9
Ability to change
There is a failure to notice/respond to change in the business environment (signs include old-fashioned products, an antiquated factory, ageing directors or no computers)	15
	15
Specific risks
The business has relatively high levels of borrowings	15
The company is overtrading (the company is expanding faster than its funding)	15
The company is exposed to a big project (where the company is at risk of collapse if failure occurs)	15
	45
Warning signs
There are real signs of financial difficulty (poor accounting ratios for sector, poor credit rating)	4
Your business employs creative accounting to disguise the difficulties	4
There are non-financial signs of difficulty (capital expenditure decisions delayed, staff turnover rising, offices in need of repair/renovation)	3
There are terminal signs (the bank is reducing its overdraft facility, creditor pressure)	1
	12
Total possible score	100

Working out your score:

Score	Result
Less than 10	There is unlikely to be any cause for alarm, but why not redo the test in six months’ time?
10-25	Some cause for concern. What issues has the test highlighted for you? What actions does this suggest you should consider taking?
Over 25	A serious cause for concern.