Small business failure: reasons, process and avoidance

Some research (Williams, 2001) and the general perception is that half of small businesses fail within a short period of time. In fact, in 1999-2000 the number of formal insolvencies economy wide was estimated at around 0.36% of all enterprises. (Bickerdyke, 2000) In 1991-1992 the figure was 1.04%, three times that ratio. Figures for July 2005 are 1.01% of companies entering insolvency as a percentage of companies incorporating. (Australian Securities and Investment Commission, 2005). Professor Michael Schaper from the ACT Small Business Review reported in the Australian Financial Review an exit rate of 8% where this rate is measure of how many businesses cease to exist. (AMP & NATSEM, 2005, P18) This is clearly well below the common belief. These figures may be contradictory and misleading but the fact remains small businesses cease to trade and this has ramifications for their owners, creditors and the economy. This paper will explore the typical reasons for small businesses ceasing to trade due to their inability to pay their debts with a detailed exploration of the process of insolvency and a look at the institutions and procedures they face. Some suggestions for avoiding such a fate will also be proposed.

The reasons for the short lived nature or insolvency of small businesses have been researched intensively over the last decades by academics and data is routinely collected by government agencies. These reasons for small businesses ceasing to trade are not mutually incompatible. According to some research the primary reason is inaccurate or non-existent books and records and the inability to use or understand financial statements and reports, (Williams, 2001 p149). . Undercapitalisation, including insufficient start-up capital and the lack of working capital is a significant factor. (Williams, 2001 p149). This can result from an inability to source finance. According to the 1995 Telstra Survey, 55% of funds come from owner’s capital and 43% from bank finance. (Jones, 2005) Successful borrowing from banks depends heavily on the owner/manager backing the application with a business plan and financial budgets including a cash flow budget. (Williams, 2001 p149) Cash flow difficulties can occur with overtrading with means the business is growing too fast. (Williams, 2001p149). Overtrading can be linked to poor inventory control which occurs when too much or the wrong type of stock has been purchased on the basis of inexperience or over enthusiasm. Poor inventory management can also mean too much cash is tied up in inventory for too long. Similarly, over capitalisation, which is the investment of too much cash in non-current or fixed assets, can impact negatively on the small business. (Williams, 2001 p149). Likewise poor control over costs and activity levels by not understanding the relationship between fixed and variable costs and their effect on profitability and the break-even point can have serious consequences for the small business. (Williams, 2001 p149). Poor control over credit can be another reason for the short lived nature of some small businesses. Slow paying debtors can misalign cash flow in that the business can be forced to be a slow payer to its creditors which can destroy its reputation with its suppliers who then may impose interest charges and restrict credit terms. (Williams, 2001 p149). Many owner managers take excessive private drawings from the business, particularly in the early stages, and can starve the business of cash flow. (Williams, 2001 p149) Fluctuating economic conditions with frequent price changes and interest rate volatility has also been cited for small business insolvency. (Williams, 2001 p149)
According to the report of the Inspector General on the operation of the Bankruptcy Act and used by the Australian Bureau of Statistics in compiling its snapshot of small business, (Australian Bureau of Statistics, 2001p78) the main reason for small business failure over the decade to 2001 was fluctuating economic circumstances, with 24% in 1983 down to 15% in 1998 and up to 34% in 2001. Excessive interest moved between 4.4% in 1983 to 9% in 2000 and back to 4.9% in 2001. Interestingly reasons with steady increases were gambling or speculation from 0.5% in 1983 to 3.8% in 2001 and personal reasons from 6% in 1983 to 17% in 2001. The lack of capital was steady at around 13% with the failure to keep proper books steady at around 1%-3%. Importantly the lack of business ability dropped from 33% to 9% over the period.
Market research is a vital part of ensuring business viability. Too often ignored by small business owner/managers who typically are convinced their product or service will work without first asking potential customers. They also fail to clearly define their target market. Price cutting is assumed to ensure successful competition. Short term thinking by underestimating how long it will take to enter a market and obtain a reasonable market share is also a pitfall to be avoided. Finally complacency in that small business becomes too reliant on promises of work when first starting. (Hingston 2001 P30)
A useful test for viability for small business is the financiers test. For example others should find it difficult to enter the market after you have entered and are successful. The business should have high margins and good profitability with good cash flows, funds for future development. Furthermore it should be able to survive if these margins are eroded. The business should appear able to survive for a number of years without requiring further investment or change. (Hingston 2001 P38) There are a number of common errors small business owners make when raising finance. Going ahead before raising sufficient funds to cover all the business needs. Predicting a higher or faster rate of sales than is likely. Not having an exit strategy. Overborrowing and then not being able to pay interest and principle repayments out of cashflow can create problems. (Hingston 2001, p66) Owners are putting assets at risk unnecessarily by not considering other security options when borrowing. Not having enough finance arranged when the business needs expansion and having to make larger owner’s drawings to meet expenses are also common financing mistakes. (Hingston 2001, P66) Being unprepared for a downturn in the economy by having borrowing arrangements in place if needed is a mistake. Not having enough cash flow to meet tax and other regular payments is common. Most of all overestimating the importance of raising finance in running a business. (Hingston 2001, P66)

Some of the institutions and procedures faced by small business when confronted by insolvency have improved over the last two decades.
The failure rate for small business in Australia in 1999-2000, at just 0.36%, was lower than a decade earlier. The decline could be the result of fewer company failures which may be explained by the changes to the Corporations Act that provided much greater scope for companies to trade their way out of financial difficulties. However the failure rate of unincorporated businesses remained relatively constant over the same decade. (Bickerdyke, 2000 P54)
A market economy based on competition will inevitably result in some businesses ceasing to trade. This should result in less efficient businesses being replaced by more efficient as measured by increased returns on capital. The OECD has noted how the entry and exit process can make a contribution to economic productivity growth. (OECD 1998 p112) However the law expects those involved to be able to recognize the warning signs early and act responsibly to avoid or lessen their creditors loses.
The small business owner may be unable to take corrective action when warning signs of approaching problems start. An examination of the financial position may indicate approaching insolvency whereby the business may be unable to pay its debts as and when they fall due. Steps may be taken to rectify the situation or to protect the directors and company officers from committing breaches of the Corporations Act. These may include an injection of capital, renegotiation of short term debt into long term debt if eventual payment is possible. This approach should only be contemplated if cash flow and profit projections support the decision. It may be possible to negotiate a rearrangement of the order of creditors. It only takes one unhappy creditor to force insolvency, so it may be wise to placate the unhappiest creditor first. (Hingston 2001, p176)
If the business can’t be saved there are a variety of possible administrative steps to be followed depending on whether the business is incorporated or a sole trader/partnership. Sole traders and human partnerships are covered by the Bankruptcy Act, 1996 (Cth) and administered by Insolvency and Trustees Services of Australia (ITSA, 2005). Incorporated enterprises are covered by Chapter 5 of the Corporations Act, 2001(Cth) and administered by the Australian Securities and Investment Commission. (ASIC, 2005)
Provisional liquidation where a creditor, shareholder or director can request the court to appoint a provisional liquidator to protect the assets of the company until an order for its winding up is made or some other action is taken.
Court approved schemes of arrangement between a company, its creditors and or its shareholders where creditors agree to stop pursuing their claims to allow the company to continue in business. The administrator may be required to cease trading, realise the assets and distribute the funds. A compromise where the creditors agree to accept an amount less than the face value of the debt.
Informal arrangements between creditors and a company where they agree to a rearrangement of liabilities are also possible. Receivership, whereby a secured creditor or the court can appoint an official receiver to either liquidate the assets or manage the business and its affairs until the secured creditors are paid in full or the decision is taken to close down the business. A creditor’s voluntary winding up involves the company’s directors and creditors resolving to wind up the company. A liquidator realises the company’s assets and distributes them among the creditors in order of priority, investigates the company and makes a report to the ASIC. (Hingston, 2001 p176)
Part X arrangements under the Bankruptcy Act have now become Personal Insolvency Agreements. Other arrangements include Part IX debt agreements and Part IV bankruptcy. Each has its advantages and disadvantages and the circumstance of each case will dictate which to use.
Irrespective of whether or not the creditors are paid out, the Australian Taxation Office requires the business to apply for cancellation of registration for GST within 21 days from cessation of trading. If the business has an ABN the ATO must be informed within 28 days to ensure changes are made to the details shown on the Australian Business Registrar. If a change in business structure is made to create a new entity an application for a new ABN must be made. (Australian Taxation Office, 2005)

The most important measure a small business can take to avoid insolvency is the same measure it needs to achieve success and that is the production and periodic maintenance of a business plan particularly including the financial statements. (Ernst and Young, 2005) The business plan demonstrates to outsiders the rational, organised process for operating the business and justifies its existence. (Austrade, 2005)
The business plan should contain:
Executive summary: explain succinctly what the business does and how it will use investor funds.
The opportunity: identify the problem your product will solve for the market, speaking in terms of customer needs.
The solution: outline your business proposition.
Market research: detail your understanding of the market and its trends.
Sales strategy: explain your proposed model for sales and distribution, including pricing strategy.
Intellectual property: set out details of any patents, trade secrets or other competitive advantages enjoyed by your business or its competitors.
Government regulation: outline any applicable government stipulations that might affect the business.
Exit/liquidity strategy: assuming all goes well; enumerate the potential returns for prospective investors.
People: provide details of key employees, advisors and other strategic personnel.
Financials: include full financial details, including a capitalisation chart, income statements, balance sheets, cash flows and shareholder structure.
Appendices: append any relevant technical or supplementary material. (Austrade, 2005)
By updating the business plan regularly it is possible to identify earlier some of the reasons small businesses stumble and be in a position to implement solutions to rectify the situation.













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