Why Do Businesses Fail?

Recent surveys show that the survival rate of new businesses average about 20% over a five-year period. In other words, if you start 100 new businesses today, 20 of them will still be in business five years from today. The other 80 will have gone out of business sometime during that five-year period. These are generally well-known statistics. What isn’t as well known, however, is that of the 80% of new businesses that failed, over 60% were profitable when they went down!

How can that be? It sounds counter-intuitive that a profitable business would fail. However, it becomes easier to understand when you consider the impact of a small business accounting term called, “payment terms.” Payment terms are a measure of the number of days between the time a service is provided or a liability is incurred and the time payment is actually made. What are the average “effective” payment terms in a typical small business?

Cash in:

  • from Customers – “average” 45 to 60 days

Cash out:

  • Rent – in advance
  • Employees – 7 to 14 days (regulated by federal law)
  • Other Vendors and Suppliers – 15 to 30 days

In other words, there is a distinct timing gap between the terms on money coming into the business and money going out of the business. When you combine that with rapidly increasing sales, you find the most common reason that the rapidly growing, “profitable” businesses failed to survive — they just ran out of cash. They had to pay their landlord, employees, and suppliers BEFORE their customers paid them — and they didn’t have enough “Working Capital” in their company to bridge that gap!

However, they didn’t fail simply because they ran out of money. According to the research, that cash shortfall was just a symptom of the real problem. The real underlying problem was that they didn’t have the management information they needed to successfully manage a dynamic business. In other words, they failed to maintain bookkeeping and accounting systems to provide them with critical management information — such as how much they had in the bank, which customers owed them and when it was due, which suppliers they owed and when it was due, etc. — the type of information required on a day-to-day basis to successfully manage a business in a changing business environment!

An Example:

Think of it like this. Imagine what it would be like to go bowling if they put a curtain at the end of the alley in front of the pins and turned off the projector for the scoreboard. How successful would your bowling game be?

You would hear the pins clattering, and someone would tell you that you have another turn — at least until the game is over. And you might have a wonderful time exercising and socializing with your friends. But what do you think your final score would be? You wouldn’t know how many pins went down. You wouldn’t know whether your ball needed to go more to the right or to the left. And at any given point, unless you’ve been keeping track in your head, you probably wouldn’t know how much more time was left in the game. Nobody would want to go bowling in that situation. Yet this is, effectively, what happens when you run your business without good accounting information!

A small business accounting firm can help you get the information you need to run your business effectively!

PASBA member accountants bring the collective resources of a nationwide network of Certified Public Accountants, Public Accountants, Enrolled Agents and other practitioners available to answer your tax and financial questions and streamline your business accounting, bookkeeping, and payroll operations. To find a trusted accountant in your area, visit www.SmallBizAccountants.com.

Please be advised that, based on current IRS rules and standards, any advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty that the IRS may assess related to this matter. Any information contained in this article, whether viewed or subsequently printed, cannot be relied upon as qualified tax and accounting advice.  Any information contained in this article does not fall under the guidelines of IRS Circular 230.

Copyright Information 2011 Professional Association of Small Business Accountants

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