Chief Executive Boards Blog: The REAL Leading Cause of Small Business Failures

Conventional wisdom cites the leading cause of small business failure as undercapitalization. In my experience (and perspective through Chief Executive Boards International) watching hundreds of businesses "up close and personal" fail, survive or thrive during this recession, I believe the leading cause of business failure is lousy financials, misunderstood by a business owner who's good at his or her core competency, but not very financially savvy. Two of my friends lost their businesses during this recession for, I believe, exactly that reason.

What do I mean by lousy financials?

Not timely -- It's not unusual for an owner to get monthly financials 2 weeks or more after the close of the month. At that point, any problem he detects in the prior month has cost him a 2-week delay in getting fixed

Late postings or postings in arrears -- This is a killer. Credit card bills come in several weeks after the fact and post charges to the prior month (that the owner didn't see, even if he looked at the month's results a week or two after month-end). This problem can be averted, using online Credit Card statements (almost real time) to post actual charges through the last day of the month, (they become payables) regardless of the billing cycle. Of course, there are multiple possible sources of late postings. Specifically, if you're not closing and controlling your accounting platform, users can post costs or credit invoices in prior periods, and you'll never see it in the current month (profits just evaporate from the YTD figures). A good opportunity for not only employee theft, but also misinformation in the current period.

Committed Costs -- Another killer. Even in simple platforms like Quickbooks, you can use an "Item Receipts" technique to post costs you know you've spent already (say, with subcontractors) in the month they're incurred, rather than having them come in 60 days later, hammering that month (while you were still feeling good about the fat month where you booked the revenue from the customer without this cost on the books).

Mismatch of cost and revenue timing -- Another killer. It's critically important to match the month in which you bill with the month the related costs are incurred -- both material and labor. Otherwise, your month-to-month performance will be whipsawed one way or the other, and you never see the budgeted business model (ratio analysis) -- how a "good" month is supposed to look

Lack of understanding of Accrual vs. Cash income statements -- One of the killer features of Quickbooks is its "dealer's choice" switching of Cash vs. Accrual on demand. Most small businesses pay taxes on a cash basis. Other than that, you want to run your business on an Accrual basis, carefully matching up the month the income was incurred (based on billing date) and the date the costs were posted (based on date spent or committed). That way, each month's income statement is a credible representation of how the business actually did that month. I've seen swings of plus or minus 200% of monthly net profit, simply due to errors of timing in when revenue and costs were posted. And, of course, if you're trying to manage from a Cash Basis income statement, it's completely warped by timing of customer payments. Worse than useless.

Lack of understanding of income statement vs. balance sheet postings -- Your vehicle loan payments aren't expense items. The interest portion is -- the principal portion is debt reduction (assuming you properly put the vehicle on the balance sheet at the outset). Many businesses expense items they're actually holding in inventory -- again distorting profitability of both the month when they buy them and the month when they sell them.

Inability to understand and forecast working capital needs -- If your accrual income statement is wrong and your balance sheet is wrong, it's almost impossible to forecast what your working capital (Inventory, WIP, Accounts Receivable) needs will be. That's like flying with no cockpit instruments. Potentially fatal.

So, why does conventional wisdom lay business failure to "undercapitalization"? I think it's because the likely outcome of lousy financials is the same as bad cockpit instrumentation -- people fly into the sides of mountains with no warning. You only get to run out of cash once -- you can come close to running out of cash a lot of times. If you're the victim of any of the above, you're a prime candidate to run out of cash. And when the mourners gather, someone says, "What happened?" and someone else says, "He ran out of cash -- he was undercapitalized." Like a lot of accidents, it didn't have to happen that way.

Two of my friends, both victims of lousy financial information, lost their businesses during this recession. They were good operators. They were good businessmen. Worse than no instrumentation, their instruments were wrong, and they ran out of cash. They had been adequately capitalized all along -- they just didn't see it leaking away in time.

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