Why Businesses Fail

There are four broad reasons businesses fail:

1. 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 the company's bank refuses to increase the company's line of credit, the company can fail. The problems with debt are:

• Debts must be repaid;
• It must be repaid with interest;
• Large creditors tend to demand collateral or security making the debtor or borrower's position more tenuous; 
• The more the customer borrows, the higher the risk;
• The higher the risk, the higher the interest rate;
• The higher the credit risk and the interest rate, the harder it becomes for the debtor to continue to borrow or to borrow larger amounts.

2. Certain companies fail to keep up with changes in demand. As a result, their method of doing business or demand for their products and services decreases to the point that the company can no longer generate a profit no matter how diligently and stringently the company reduces its costs.  Companies that do not invest adequately in infrastructure upgrades are in research and development will find it increasingly difficult 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. Companies are mismanaged. Mismanagement can be seen from a distance in a variety of forms. Examples include:

• Companies that under perform financially relative to their competitors;
• Companies that fail to thrive even in good economic 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. The failure results in part or in whole as a result of fraud or embezzlemen. 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. 

Copyright 2010 by Michael C. Dennis.  Mr. Dennis is a consultant and can be reached by email at mcdennis13@yahoo.com