Identifying Business Failure and Making Critical Investment Decisions

When faced with signs that a business may be failing, it is crucial to make informed decisions about whether to continue investing. This guide provides insights and tools to help you assess your company's health and make the best possible choices.

The Signs of Business Failure

Several factors can indicate that a business is in trouble:

No one is buying services or products. The market demand for your offering has shifted. You cannot deliver what the market wants. Your business model does not allow you to charge enough to be profitable.

My own experiences have shown me that these are common reasons for business failure. While my core business started in 1983 and still stands, I have faced similar challenges in various companies over the years.

Assessing Business Health

To determine the health of your business, follow these steps:

Cash Flow Analysis

Obtain the cash flow statement and examine the bank balance as of the current date. Calculate the monthly cash flow the business generates. Subtract debts like payments to vendors, interest on loans, payroll, and other operational expenses. Compare the results for a monthly, quarterly, and half-yearly period to understand the business's performance over time.

Identify months where the business is "unit profitable" versus those where it is "unit non-profitable."

Financial Reports and Ratios

Review the Tax Compliance and IT return reports to ensure net profitability. Check if depreciation is being offset against taxes. Examine the balance sheet to see the net immovable assets and cash on hand.

Drop Dead Date

Determine a 'drop dead date' beyond which you will not invest or recapitalize. This self-critique tests the viability of your business idea. Even if you initially believed your idea would generate massive cash flows and turn you into a millionaire in 24 months, reality may differ. Making money is not always easy, and businesses often feed on their cash flow.

Calculate if the cash flow is net positive or negative. A small negative cash flow can lead to a devastating financial crisis over time. For example, if payroll becomes a risk, it is a sign that the current cash flow is negative.

Strategies for Business Recovery

If you determine that your business is net negative, consider the following strategies:

Scaling Back Operations

Reduce high outflow operations to minimize the financial drain. However, be aware that this will also impact revenue.

Be prepared for a challenging transition, especially for founding members who tied their exit plans to rapid growth. Suddenly, “growth” turns to “de-growth,” and then “negative growth” before the business can recover.

Funding and Cash Management

Using venture capital (VC) funding can provide a temporary boost, but managing the burn rate is crucial. Sales and marketing teams often delay campaigns, claiming system readiness, while operations and sourcing teams request more time, and IT teams face capacity constraints.

The critical components of business growth, including IT systems, are often overlooked. Delays in payment to vendors or debtors can accelerate the business's decline.

Financial Ratios and Data Analysis

Utilize financial ratios such as Return on Capital Employed (ROCE), Debt to Equity ratio, Quick Ratio, Earnings Per Share (EPS), EBITA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and Price-to-Book value to make strategic decisions.

Data analysis can provide crucial insights into the business's financial health. These metrics can guide you in making informed decisions about future investments and funds allocation.

In conclusion, the cautionary instincts that have evolved over generations remind us to be wary of potential business failure. Effective financial management, realistic assessment, and proactive decision-making will help safeguard your investments.