Common Sources of Business Failure

This article aims to explain the common sources of business failure. Firstly, the term "failure" is defined, then common causes of failure, as well as other influencing factors of failure, are listed. Finally, it tries to explain to the reader the impact of failure - on a business, an entrepreneur as well as on society

What is Failure?

The term ‘failure’ is used loosely in business and may describe any of the following conditions or circumstances:

• Financial distress
• Voluntary closure due to inadequate returns
• Cessation of trading
• VAT deregistration
• Company deregistration
• Personal bankruptcy
• Insolvency
• Liquidation

Common Causes of Failure

There are several causes of failure. For convenience, these causes are divided into 4 categories: Market, Financial, Operational and Human.

Market

• Market decline (or over-optimism)
• Increase in competition
• Loss of competitiveness

Financial

• Overtrading - or a single 'big project'
• High gearing
• Under-capitalisation
• Inadequate cash management
• Inadequate controls
• Excessive drawings

Operational

• Business location
• Over-ambitious startup
• Over-optimistic cost estimates

Human

• Imbalance or inadequacy in areas of management
• Loss of interest or drive by owner-manager
• Loss of leadership and direction
• Inadequate / inappropriate recruitment

One recent study found the following factors to be significant in determining if a business is to fail (in rank order):

1. Lack of knowledge of marketing
2. Competing task demands from family / domestic sources
3. Problems of outlets
4. Lack of market awareness of product / service
5. The costs of business premises
6. Inappropriate business premises
7. Insufficient mark-up
8. Unacceptable risk
9. Change in home circumstances
10. Inappropriate size of premises

Failure Prediction

In broad terms, failure might be as difficult to predict as growth, but the fact that most involuntary closures are caused by cash insufficiency or insolvency means that financial data and ratios, where available and reliable, can be used to predict the risk of failure with some accuracy. These indicators might include gearing, profitability and performance ratios but also other financial data such as changes in owner remuneration.

However, financial data notoriously suffers from unavailability, inaccuracy or lateness. Numerous other indicators may also be useful in anticipating distress or failure, including:

• redundancies
• delay in submission of published accounts
• audit qualifications
• changes in legal form
• changes in management structure
• reduction in stock levels
• issue of round-figure cheques

Factors influencing failure

Below are some of the factors that can be useful in assessing the risk of failure of a business:

• Age of firm - the longer the firm is established, the less likely it is to fail.
• Size of firm - the larger the firm, the less likely it is to fail
• Growth - firms that grow are more likely to survive
• Macro-economic conditions - failure rates increase during a recession
• Sector - failure rate is higher in some industrial sectors
• People - there is some evidence that failure rate is inversely related to educational level, age and prior experience of the owner-manager
• Firm type - There is a lower failure rate among franchises
• Location - Failure rates are somewhat lower in rural areas

The costs (and benefits) of failure

Costs

• Loss of entrepreneur's and creditors' capital with resulting 'domino effect'
• Injurious psychological effects:
  - Damage to self-esteem
  - Return to employee status or unemployment and social marginalisation
• Economic effects of reduced national and local tax revenue, increased social security payments and impact on local economic development

Benefits

Failure allows for the release of resources for productive and efficient use

• Failure can be a learning experience - ‘an essential development of the entrepreneurial personality'
• Hence potentially greater development capability of enterprises founded by entrepreneurs who have failed previously

Conclusion: Tolerance of Failure

The process of failure can be a very valuable learning experience but:
‘ in Britain, our culture is less tolerant of failure and too often highly talented individuals have not been able to recover from failure’
whereas
‘ in the USA failure is viewed as a learning experience and people can benefit from failure, can learn from their experience and go on to form successful companies as a result’
It is sometimes said that a ‘failure-tolerant culture’ is necessary for the support of entrepreneurship, both in society at large and within the organisation