Many new businesses emerged. But, most of them failed to grow bigger. For example, in the United States, 30% of new businesses fail during the first two years of their operation, 50% during the first five years, and 66% during the first 10 years.
The reasons small businesses fail
Various reasons explain why small businesses fail. Inadequate capital and resources are among them, which causes their competitive capacity to be low. In addition, problems in production, non-strategic location, and poor cash flow management are other causes. It all comes from internal factors.
Then, failure can occur due to external factors. For example, economic shocks such as recession, high interest rates, changes in technology, and consumer tastes and preferences can also threaten businesses and lead to failure. Another external factor is competitive pressure, where small businesses have to face established competitors.
Limited access to funding
All businesses need funds, especially for fixed assets, such as buildings, machinery, and equipment. They contribute to the high initial production costs of a business.
However, buying these assets requires considerable funds. And, most small businesses will rely on external funding, such as through bank loans.
The problem is, not all of them have access to external funding. New businesses don’t have a track record of convincing banks to make loans.
Even though businesses can borrow money, they bear relatively high-interest expenses. That, of course, affects their cash flow position. Often, new business owners have to mortgage their own property as collateral for a loan.
Asynchronous production with demand
New businesses are more likely to experience overproduction or underproduction. They usually have difficulty estimating demand levels accurately.
The business may produce more product than the customer is asking for. That results in excess production and leads to hoarding, waste, and increased costs.
Conversely, underproduction leads to customer dissatisfaction. They are unable to get products on time. In the end, sales are not optimal.
Less strategic location
Businesses often face dilemmas in their decision on where to operate. Ideally, they operate in a strategic location, close to customers. That way, they have access to a large number of potential customers.
However, strategic locations such as in the city center are expensive. Fixed costs, such as lease or mortgage payments, make up a significant percentage of businesses’ total costs.
For such reasons, many entrepreneurs set up small businesses and operate initially from their own homes. It saves fixed costs and benefits in terms of taxation. The small fixed costs allow them to break even immediately.
Cash flow problems
Cash flow management is another issue for many new businesses. They often have difficulty generating sufficient inflows. If it continues over time, it causes liquidity problems.
New businesses may have too much inventory in their warehouses, such as raw materials or semi-finished goods. They stock it to anticipate a sudden increase in the demand because of the customer’s positive response to their first sale. As a result, more money is tied up in inventory, and it takes some time to convert it into cash.
Furthermore, the customer may also demand an extended credit period. That means the business won’t receive a cash payment until the credit period has ended (typically between 30 and 60 days). At the same time, the business must pay operational costs such as wages, rent, utilities, taxes, and interest payments.
Low market and marketing knowledge
New businesses have insufficient knowledge of the market. They may misidentify the selected market segment.
Or, the segment may be profitable and large enough. But, new businesses do not know about marketing and how to attract customers to buy products.
As a result, new businesses fail to meet customer needs and expectations. They offer products with attractive features, but the prices are too high. Or vice versa. They offer low prices, but product features are unsuitable to consumer preferences. Ultimately, it leads to low sales.
Lacks a customer base
Building a customer base is the first task. It is essential to ensure sales going forward.
And, building a customer base is a difficult task. Businesses must educate consumers to increase their awareness of products. At the same time, they must also charge the right price and offer the right quality to attract customers.
Some new businesses may choose to set a market penetration price. They sell new products at low prices to attract customers to try and buy. Offering low prices is easier than differentiating products.
Difficulties arise because new businesses have to face several established competitors. Customers may be loyal to competitors’ products and reluctant to switch to new products.
Although it can divert some customers from competitors, customer loyalty is usually low. They may buy it because they just want to take advantage of the low price.
Weak human resource management
New businesses may lack experience in recruiting the right staff with the right skills. That can lead to low customer service levels and inefficient operations. Additionally, new businesses may not have an ideal and flexible organizational structure that best fits their needs.
Businesses must comply with all required laws. Examples are business registration procedures, insurance coverage for staff and premises, consumer protection laws, and copyright laws.
The paperwork and legal requirements for setting up a new business can be tedious, confusing, time-consuming, and expensive. Any oversight can result in the business having to bear penalties.
High production costs
New businesses have high production costs. They bear enormous fixed costs, such as paying for equipment, machinery, and rent.
At the same time, sales are low as they are still building the customer base. As a result, they have not yet reached economies of scale. And, it causes high unit costs at the start of new business operations.
Changes in the external environment
Regardless of how large they are and how long they have been operating, all businesses are vulnerable to changes in the external environment. It can come from various sources, including technological changes, economic shocks (such as a recession), high interest rates, and changes in consumer tastes and preferences. Such changes pose a threat and disrupt the business, which can lead to failure.
New businesses are more vulnerable to such external pressures. This is because they do not have adequate resources and capabilities to deal with external threats. Thus, they are more prone to failing to deal with external threats than their established competitors.
Insufficient management skills and experience
Poor management explains why small businesses fail. Owners often do not have sufficient expertise in functional areas such as purchasing, marketing, finance, production, and employee management.
Such shortcomings are often inherent in sole proprietorships, where the owner is responsible for the entire operation. These business organizations also find it difficult to hire experienced staff because they prefer to work in established companies.
Threat of competition
Small businesses have low competitiveness. They have more limited resources and market knowledge than more established companies. They operate at low economies of scale with limited capital.
Expanding, it is also difficult to raise funds because the capital providers are reluctant, considering their high failure rate.
As a result, when established companies pursue aggressive competitive strategies, they find it difficult to stay in the market.
Excessive investment in fixed assets
Fixed assets consume costs. Businesses have to spend a lot of money to buy them.
Then, to break even and operate them optimally, the business must sell more output. Otherwise, the business bears high costs, leading to business losses and failures.
Poor debt management
Small businesses incur a high cost of funds because banks and other lenders usually charge high-interest rates. And poor credit management can result in them taking on too much debt.
As a result, businesses have to spend regular money to pay interest. They have to keep paying it even when their income is equal to zero. Failure to pay can encourage creditors to file for bankruptcy.
Using business money for personal purposes
Under a sole proprietorship, the business money is the owner’s money. The owner is not only responsible for all operations but is also entitled to all business profits. No separation is for the business assets and the owner’s personal wealth.
Thus, owners are more likely to use business money for personal purposes. If it happens, it could cause the business to run out of cash.
Bookkeeping is a key aspect for various purposes. For example, it serves as a reminder about paying interest and debt, collecting payments from customers, and paying suppliers. Analyzing finances and compiling financial reports also requires keeping records of business financial transactions.
Improper bookkeeping can lead to wrong decisions or maybe even a fine. For example, the government imposes sanctions if businesses are late in paying taxes. Suppliers are reluctant to sell inputs to businesses if they continue to be late paying. Customers prefer to delay payments because businesses don’t immediately charge them when they’re close to maturity. Such examples can lead to poor cash flow management.
Targeting the wrong market can result in small businesses being unable to sell a product. They may target everyone because they are tempted by the large size of the market. It doesn’t go well because such a market has many established competitors.
Or, the owner may be targeting a narrow market niche. But, because of research failures, they don’t know what customers want. They are just optimistic and think their product is selling well and fail to realize that no one wants their product.