Exploding some of the Myths of Business Failure
One of the frustrating things about working in trade credit management in New Zealand is that there is very little good statistics-based research available to answer the question - what are the signs that a business is going to fail?
Probably the best information comes out of Dun & Bradstreet Australia. In matters of business and law, Australia and New Zealand are probably as alike as any two countries in the world. Their company law and bankruptcy law are very similar to ours. Their procedures for debt collection through the courts - judgment, examination, distress warrant, attachment order, etc - are called by different names in many cases and I think it's fair to say that ours are more effective, but they work along the same lines. So we can assume that their research into why Australian businesses fail is probably valid for New Zealand businesses.
This research was carried out very simply. D&B took every Australian business that failed over a selected three month period, and a control group of businesses that hadn't failed. They looked at what they knew about them twelve months earlier. They were looking for factors common to all or most failed businesses, which could be seen a year before they failed. At the same time, they were also looking for factors which pointed to a business not failing. The research is probably most interesting in the myths that it explodes.
Myth number 1: One man businesses are the biggest risk.
Overall, it can be assumed that large businesses survive better than small. Businesses with over 75 employees were significantly more likely to survive. But one person businesses, surprisingly, turned out to have less chance of risk than small businesses which employ staff. In fact, the greatest level of failure is for businesses with between two and six employees. On reflection, this does make sense. A one man business has lower overheads and more flexibility - the boss can reduce the amount he pays himself more easily than he can reduce the wages of staff.
Myth number 2: Most businesses fail in the first year.
The number of businesses which fail in the first year is often exaggerated. (I have heard a New Zealand politician boldly claim that 80% fail in the first year.) In fact, few businesses fail in the first year, and relatively few in the second year. This is backed up by studies in other countries. Years three to eight account for 60% of the Australian failures.
I can suggest three reasons:
- The fact that there are delays in the collection process and legal system which prevent a creditor from winding up a company instantaneously. In other words, a debt might be three months old before it goes to a debt collector, then there might easily be another six months of negotiations and legal delays before a court finally puts the debtor company out of its misery. This reason doesn't give creditors a lot of comfort, because it suggests that the business has been struck by a terminal illness earlier - perhaps in its first year - but no-one has put it out of its misery until some time later.
- Arguably more important, however, is the fact that most businesses start with some money, either from savings or borrowing, and take at least a year or two to work through that money before they fail. It takes extreme incompetence to fail quicker than that.
- An interesting theory of small business failure suggests even though the small business-people know their new business has major obstacles, or that the business they have invested in is fast going down the gurgler, they carry on regardless, and this is why they fail. In other words, they are unable to face reality and cut their losses. Therefore they stagger on until the third year or later.
Implications for creditors
These two factors have interesting implications for creditors. A lot of creditors are reluctant to extend credit to new businesses and to very small (for example, one person) businesses. They demand cash, say for the first year. Then they conclude that the business has proven itself and allow it credit terms. (Of course, in a competitive industry, the customer may well have gone elsewhere, to a firm that will give credit.)
This research suggests that perhaps that approach is flawed. The smart credit manager might look at a new, one person business and think to herself:
"This business is probably going to survive for at least two years. I will extend credit, within reasonable limits, for the next 18 months, watching it carefully the whole time. If, at the end of 18 months, it's thriving, I continue to offer credit. If, as I suspect, it looks shaky, I stop credit and collect any outstanding debt. If I miss out on what's owed for the last month's credit, too bad. The profit from the previous 17 months sales should mean that overall, we come out ahead. If it ultimately survives, again, too bad. We win some and we lose some."
Trade references
Another important factor is trade credit references. I wanted to mention this because in the past I have, on the whole, been sceptical of the value of trade references. My view has been that most credit applicants are usually not stupid enough to direct a creditor to the suppliers they are not paying. They only provide the names of those they are paying. However, the research shows that if the creditor can find referees who say they are not being paid within 90 days - even for small debts - this is a bad sign. It's also a bad sign if creditors can't find referees in situations where they know they should be able to. In other words, the credit applicant isn't providing referees because no-one will give them a good reference. Two out of every three businesses that failed within a year had trade references showing accounts not paid within 90 days, or had no references.
Of course, it also means that one out of every three businesses that showed this factor didn't fail within the twelve months. Even good research can't predict the future in all cases.