It is often reported that most small businesses fail within the first 5 years. The table below shows that of the businesses that started in 2007 only 80% were in business 2 years later only 44% remained in business after year 5. This means that a whopping 56% of businesses cease to exist within the first 5 years of their life.
Percentage of businesses that remain in existence since 2007
Source: ONS Business Demography 2013 Release date 27/11/2014
The North East has a marginally worse survival rate than does the rest of the UK however the picture is the same across the country – the odds are against business survival after 5 years.
Why Businesses Fail
The most obvious reason for business failure is a lack of cash but why do business run out of cash. According to David Mellor writing in The Guardian Small Business Network there are three key reasons:
Lack of awareness; new business owners don’t know what they are letting themselves in for. There has been inadequate research and homework into the industry, owning and managing a business and straightforward commercial awareness. Furthermore the further the chosen industry or sector is from familiar territory the greater the risk of failure.
Getting paid; bad debts are a major problem for all business but particularly small business. Insufficient capital will strangle your business over time but running out of cash will destroy it in a heartbeat.
Having the wrong partner; people go into business with insufficient knowledge and formal guidelines. It is recommended that any partnership or company with more than one director has a formal agreement that details the rules and regulations of the business. It is wise if there are any doubts, even the smallest, that the venture does not go ahead unless the doubts can be removed.
Late Payments
Taking the second point, failing to get paid, the Federation of Small Business (FSB) reports that around 73% of small businesses have experienced late payment in the last 12 months. Most companies state that it is the private sector that is most at fault but the public sector can be late payers as well.
FSB members report that the impact of late payment is a reduction in profitability, late payment of suppliers and a restriction of business growth. The reduction in profitability comes from the additional expenses incurred as a result of chasing debts through time, legal costs and writing off bad debt. In addition the business may need additional borrowing to pay suppliers and this comes at a cost.
It is also important to remember that when a large business fails to pay its suppliers on a timely basis there is a ripple through the supplier chain. As one small business is not paid so it cannot pay its suppliers and so on.
Profitable, growing businesses can go out of business because they have run out of cash. This is because the owner and/or manager has underestimated the increase in cash that is necessary to keep the business going. A business needs a certain amount of money to keep going – to pay suppliers, employees, to buy inventory and equipment. This is called working capital. As a business takes on more work so it needs to invest in more staff, more equipment, indeed more everything and so working capital increases as well. Staff need, expect, to be paid every 30 days or so and usually suppliers need to be paid more quickly than customers pay. Failing to properly forecast the cash requirements of growth will mean that the business risks running out of money before the new customer pays their debts.
The first table shows stable cash in flows from receipts and outflows to payroll and suppliers. However a company that elects to grow also chooses to go through a period of change and instability. Acquiring new customers will almost invariably involve investment in new equipment, additional staff and more products and services from suppliers in order to service the expected new customers. The table Cash Flow with Growth shows the dramatic impact that growth has on the cash balance. The negative cash balance must be funded by the business somehow whether through additional funds from the owner, bank overdraft or another source.
Now consider what happens if the cash in flows from the customer are delayed, a common occurrence. This may be because of delays in rolling out the new product, delayed customer acquisition or delayed payment by the new or existing customer. A delay in receipts from the customer by just one month results in the business have to fund a negative cash balance for five months or even more rather than moving into a cash surplus after 4 months.
Conclusion
The table shows clearly that is possible for a profitable, growing business with a full order book can go out of business because a major customer pays late or not at all. It is vital to forecast cash in flows and out flows. Furthermore it is essential that actual cash movements are monitored to see whether reality resembles the forecast or whether action needs to be taken because cash in flows are behind expectations, or cash out flows are ahead of expectations. You can also see that a new business, or a growing business, is at great risk of failure and adding to the statistics, despite being profitable and having a full order book entirely due to running out of cash.
Bridget Holmstrom
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