Why Businesses Fail

There are four broad reasons for business failure:

1. A number of businesses are under-capitalized and consequently become over reliant bank and trade creditors to provide financing. If an under-capitalized company's creditors shorten the terms of sale, or reduce the credit limits offered, an under-capitalized company can quickly become financially distressed. If a bank refuses to continue to expand the company's line of credit, the company can fail. The problems with debt are:
   • Debts must be repaid sooner or later
   • It sometimes must be repaid with interest
   • Large creditors tend to demand collateral or security making the debtor more tenuous
   • The more the customer borrows, the higher the risk. The higher the risk, the higher the interest rate and the harder it becomes to continue to borrow
     
     
2. Certain companies fail to keep up with changes in demand. As a result, their method of doing business, or their products and services become obsolete. Companies that do not invest adequately in infrastructure upgrades will not be able to compete with companies that have made these investments. Some companies fail to change their product mix in response to changing demand. As a result, their inventory becomes stale and eventually almost valueless. This can also lead to business failure or bankruptcy.
   
   
3. From the credit manager's perspective, perhaps the most troublesome is a customer that is poorly managed and fails as a result of mismanagement. Mismanagement can be seen from a distance in a variety of forms. Examples include:
   • Companies that under perform financially
   • Companies that fail to thrive in good times
   • Companies that fail to set aside financial reserves for tough times
   • Companies that fail to plan
   • Companies that fail to take advantage of opportunities, and
   • Companies that struggle and fail when adversity strikes
     
     
4. Fraud or embezzlement is a growing problem as are many so-called white-collar crimes. Operators of business frauds are becoming increasingly sophisticated. For example, many have learned to use the U.S. Bankruptcy Court as a way to hide the fraud and confuse creditors. It is hard to know how many business bankruptcies and failures are caused by insider fraud - rather than simple mismanagement or bad luck.
   

Source: Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore.