Why is it important to know the symptoms of impending business failure? So that timely remedial actions could be taken to restore the business to the position of viability..
There are different degrees of business failure. It may be a mild case of short falls in cashflow expectations which though weaken the business but don’t threaten the existence of the business. That is, the business is technically insolvent.
Or it may be a degree of failure associated with a negative net worth where the business seeks the bankruptcy court’s protection from its creditors. It may also be the most severe case that requires the liquidation of the business.
What are the common causes of business failure?
- Poor management is one of the common causes of business failure. Successful management of a business depends on the sufficiency of necessary skills, a strong sense of responsibility, relevant experience and high financial discipline by managers. The absence of any of these qualities produces poor management.
2. Undercapitalization: This is the most common cause of business failure among startups and small businesses. A business that uses excessive debt in the short term for financing may face a situation of lack of funds when it’s unable to meet obligations of a maturing debt.
This inability may be due to inadequate cashflow. A business experiencing undercapitalization at the initial stage may not be able survive larger than expected losses and delays in revenue generation.
3. Poor marketing strategy: This is another common cause of business failure. A business that fails to carry out effective marketing research will not design an effective marketing strategy that guarantees high volume of sales. It could end up with a marketing campaign that is based on an incorrect marketing mix, which doesn’t maximize response of potential buyers and profitability.
4. External factors such as adverse government policies could cause business failure.
What are the symptoms of business failure?
There are statistics that give warning signs of business failure. These are;
- Market price: An increasing decline in the median market stock price is an indication of investors’ decreasing confidence in the survival of the business. So, business failure is approaching when the market price begins to decline at an increasing rate.
2. Working capital/total assets: As business failure approaches, this ratio declines reflecting the inadequacy of working capital.
3. Earnings before interest and taxes/total assets: This ratio shows the relationship between the lack of an adequate cashflow and the business’s debt obligations. As it gets lower and lower, the business’s ability to meet those obligations gets lower too.
4. Cashflow/total debt: This ratio falls rapidly as business failure approaches.
5. Retained earnings/total assets: This is the ratio that indicates the lack of adequate cushion to withstand temporarily adverse conditions due to bigger than expected costs, delays in revenue generation and credit crunches. The ratio declines as failure approaches.
6. Sales/total assets: This ratio shows a diminishing market for a business with the capacity to produce but no sales. The ratio also defines the size of the business in terms of sales. As this ratio declines, business failure approaches.
7. Market value of the equity/book value of the debt: This ratio indicates falling stock price exposed to increasing financial risk due to excessive use of debt.
In conclusion, a failing business could be negotiated out of the situation. The business could submit itself to voluntary reorganization, voluntary liquidation or could seek legal protection where voluntary arrangements fail.