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What are the top 5-10 reasons why small businesses fail within their first year?
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7 Answers
We are quite sure that many business owners and financial managers, and to some degree even sophisticated financial analysts have never heard of Edward Altman. Altman was a pioneer in financial research into trouble firms. He was a New York professor/scholar .Obviously this took a lot of what we could call ' back testing ' - that is to say going back in a companies history to determine why they failed and what were the financial characteristics of that failure . A lot of his work revolves around the in depth analysis of 33 firms that went bankrupt eventually.
Altman wrote volumes on companies in distress and bankrupt companies, and is most known for his contribution of a short formula called 'THE Z-SCORE '.
What is the Z-SCORE? In essence it's a predictor of bankruptcy and business failure! One might think the formula is overly complex, but it is not. It is simply an analytical tool that could be used by any business owner, financial manager, or for that matter a personal investor looking to purchase a stock in the stock market. It is somewhat of a dramatic statement, but Altman felt you could predict the bankruptcy, in many cases, several years before the actual event. (Short sellers of stock take note!!)
Altman developed the tool in the 1960's and we feel it is still very valid today. The ultimate result of a Z-SCORE calculation is an absolute number. If firms have a score of 1.8 or less Altman maintains the company is a strong credit for bankruptcy.
How is the score calculated? Again, readers will be surprised at how easy the score is to calculate. Remember that the absolute number of the score essentially is a reading on the company's financial health.
The elements of the score are as follows:
Working Capital
Total Assets
Retained Earnings
Earnings/Profit
Sales
Total liabilities
Note ** If any business owner does not know how to get those numbers from his financial statement we suggest they are already headed for business failure!
The calculation is done as follows:
Working Capital divided by Total Assets
Retained Earnings divided by total assets
Earnings divided by total assets
Retained Earnings divided by Total liabilities
Sales divided by Total Assets
Each number is calculated and then added up. The result is a final Z-SCORE. Remember that we have said that if a company has a score of less than 1.8 Altman. (Note there is a weighting assigned to each calculation also - readers can do their own research on the calculation)
Believed they were headed for bankruptcy. Obviously when he back tested those financials of firms that ultimately failed he showed they had exhibited a score of less than 1.8 much earlier.
Altman noted that firms with a Z-SCORE of greater than 3 were, in general, strong financially. Readers can also guess that a company with a score somewhere in the middle is a firm in the 'grey zone '. The bottom line - lower is worse!
So would you invest your personal money in the stock market in a company that had a Z-SCORE of 1.8? And do you believe you have a tool that can effectively predict the ultimate failure of a company. And finally, do you know the Z-SCORE of your own firm as a business owner or financial manager - we have shown that it is not hard to calculate. We note that ALTMAN did feel strongly that the formula works better for larger corporations. What the reader does with that data is a subject of another discussion
No formula is absolute, but, the weight of evidence suggests that if Ed (his formula /model) is predicting something, we should listen!
Hi Jeff, I'm not sure I can measure up to Stan's articulate response :-D
In the 13 years we've been working with small business owners, we've discovered (through our own informal information gathering) three primary reasons for businesses not necessarily failing but certainly causing them to struggle:
1. lack of self-esteem/belief in self
2. lack of plan
3. not executing when a plan exists
I would add to Jackie's list two other critical items:
1. Misjudging whether or not the product or service they are offering is something the market wants or needs. I can't tell you how many times I've heard from and/or advised would-be entrepreneurs who are absolutely positive that the world will beat a path to their door, and who are unwilling to listen to any challenges to their beliefs and assumptions. As Jackie mentioned, belief in oneself is important, but it must be tempered with a dose of reality and open-mindedness.
2. The most obvious--and arguably common--reality: Money, money, money. Whether people like to hear it or not, without sufficient capital the odds are heavily stacked against almost any business.
Excellent answers! In my experience, businesses typically fail for two reasons, both already mentioned but definitely worth mentioning again: lack of planning and follow through, and not having the capital to follow through effectively.
Without an extensive plan, both big picture and short-term, that outlines where you are, where you are going, and how to intend to get there, the odds are stacked against success. In fact, with a solid plan many of the lack of capital issues can be addressed and solved before it creates a dead stop for the business.
Speaking more directly to micro biz and self employed I would say the #1 issue is that being good a something or having a great product is only the start not nearly enough to get you to the finish line.
You need to become a master plate spinner - effectively shifting energy and focus between serving customers, developing self-leadership, handling the financial side, continuing to improve your skill or product, mastering marketing and exploring technology and how to use it. You can only focus on one but you need to pay attention to them all to know when any one needs additional energy and effort to keep the momentum.
I agree. Having a specialist skill/ expertise is the start. The common perception is to nurture a skill and then set up on your own. This works as long as the person can manage the skill as a business. A common example, here is software development. Because there was high demand for software developers a lot of the software developers were happy to set up on their own only to find out their lack of business management skills and expertise let them down as their businesses grew.
I would say the lack of business management skills and expertise would be one of the single biggest cause that can explain the lack of planning, the lack of understanding of the risks and complexities of growing a company, the lack of the execution of a plan, etc.
I would disagree that money is the concern it is commonly made out to be. I feel if you look into why money is such a commonly quoted concern you will find the lack of management of the money or lack management of other parts of the business which translates into the lack of money.
Look forward to other comments.
Great answers...my only comment for small business failure can be summarized in 3 words: Cash Flow Management.
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