Estimates are that one in three new small businesses in Australia fail in their first year of operation, two out of four by the end of the second year, and three out of four by the fifth year.

But it should cause no surprise when you consider that only a small number of businesses conduct a formal feasibility study and prepare a business plan before they commence the business: estimates are that only three to five per cent of Australian small businesses starting from scratch prepare a business plan – that is, know that their business is feasible and have a formal plan to operate that business.

Understanding the common reasons for business failure will help form your plans to avoid these pitfalls.

According to a recent study by the University of Technology, Sydney, commonly cited reasons for business failure are, in order of frequency: financial mismanagement, bad management, poor record-keeping, sales and marketing problems, staffing problems, failure to seek external advice, general economic conditions and personal factors.

A closer look at these findings is instructive. The single largest contributor to business failure is financial mismanagement, responsible for 32 per cent of all business failures. The range of problems that combine to make up financial mismanagement are lack of business experience, cash flow problems, being undercapitalised at the start, excessive private drawings, overuse of credit, no budgets and inadequate provision for tax payments.

Fifteen per cent of businesses fail specifically due to incompetent management largely arising from lack of experience. Among failed businesses, 12 per cent have inadequate or inaccurate records. In some, case records and books are totally absent.

Ineffective sales and marketing problems undermine 11 per cent of businesses. Among the critical problems that fall under this category are poor promotion, inability to cope with seasonal factors and insufficient knowledge of competitors.

Staffing problems, including lack of supervision, are also said to cripple nine per cent of businesses. Surprisingly, only three per cent of businesses fail to seek external advice in times of crises. Looking at the larger picture, general economic conditions are mentioned in 12 per cent of failures. And personal factors like divorce, illness and changed personal situation ruin six per cent of businesses.

Other frequent causes of failure include:

• insufficient sales, too few customers compared to the cost of operating
• poor location and lack of customer convenience
• bad costing, delayed invoicing
• giving too much credit, resulting in bad debts and slow payment
• inventory problems – slow-moving or dead stock and shortfalls
• inability to borrow funds
• poor staff, customer and public relations
• let down by suppliers, inability to obtain raw materials as required
• poor promotion, marketing and advertising causing poor image
• poor quality workmanship, inadequate quality management
• lack of industry or product knowledge, or lack of knowledge of market forces
• poor cash control and pilfering of goods / cash / profits

In most cases, it is a combination of several reasons that ultimately causes the failure. Often many of these factors merge or shade off into one another, leading to something like a chain effect.

Any entrepreneur keen on avoiding these traps should first of all do a feasibility study and then, depending on the results, determine their strengths and weaknesses (SWOT analysis) and draw up a formal business plan.

1. Feasibility study
2. SWOT analysis and action plan
3. The business plan

About the author: John Petty FCPA