The 5 steps of business failure, and how to avoid them

Official figures reveal a notable increase in individuals seeking debt relief, while corporate insolvencies are at a level not witnessed in the past 13 years.

Data from the Insolvency Service, which covers England and Wales for the second quarter of the year, disclosed that 6,342 companies became insolvent in the three months leading up to June. This represents a 13% surge compared to the previous year and marks the highest number of insolvencies since the second quarter of 2009.

Among the insolvencies, creditors' voluntary liquidations (CVLs) were particularly prominent, with 5,240 instances reported. This figure is the highest recorded for a quarter since such records began.

These statistics reflect growing concerns about the impact of rising living costs and business expenses, which have affected the country following the conclusion of the COVID pandemic and the financial assistance provided to support workers and companies.

As the UK economy flirts with recession, market analysts Plimsoll has issued a timely reminder that irrespective of what is happening in the wider economy, good companies survive even the worst recession.

Poor companies fail when conditions change, the unexpected happens or their financiers lose faith. Despite what the protagonist will tell you, the final catalyst is often simply the straw that broke the camel's back. Their inherent financial weaknesses, left to fester,  makes them vulnerable and eventually lead to their downfall. 

Plimsoll specialises in helping companies assess their own health and benchmark their business alongside their main competitors and key market averages.

With that in mind, Plimsoll has mapped out the FIVE steps failing companies take on their road to ultimate failure. With 9 out of 10 companies currently in administration rated as DANGER by Plimsoll up to 2 years ago, these steps are proven predictors of corporate distress and early warning of potential failure.

Business leaders have the opportunity, at any point to remedy the issues. Good companies fix the problems at step 1, the very first step. Those that make it to step 5 often find it’s too late and look for someone to buy the business or they fall into administration.

Step 1 – Falling sales from assets and investments made.

The first step towards a business failing is when sales start to fall relative to assets and investments. For many companies, this can be a sign of falling demand or a late product life cycle. They have the same fixed costs, but demand is no longer keeping up.

Other companies get caught in the hubris of sales growth and invest in a rapid expansion that never materialises.

This first step is crucial for business longevity. On review, is your company as efficient at generating sales from its assets as it was? If not, you have two choices 1) generate more sales from the same asset base or 2) reduce your investment and even the size of your organisation to refocus on the more sales-efficient elements.

Step 2 – Declining profitability

Companies that fail to assess and tweak their efficiency in generating sales from their assets, will see profits come under pressure. Companies celebrating growing sales often get lost in the headline rates without managing the business’ ability to make the right level of profit.

Sales, even much higher sales, that are generated at a lower rate relative to investments made are, by their very nature, much less profitable. If Company ‘A’ generates £1m of sales from 200k of assets employed and Company 'A'  generates £1.5m in sales from £400k of assets employed, the first company is more financially robust.

For Company B the cost of employing those assets will have doubled but sales have only increased 50%. Therefore, margins will inevitably fall. There is still time at this stage to reassess which parts of the business are delivering a profitable return.

Step 3 – Reduced working capital

Temporary, short-term falls in profit margins can be absorbed. All companies that invest for growth would argue there will be a period where new investments need time to get up to operational capacity. This can be especially true expanding into new markets or products.

However, a prolonged reduction in margins eats into the working capital of the business. Eventually, that leaves the company in a vulnerable position where any unexpected costs or disruptions can cause significant losses. The company’s ability to cover its debts without needing to sell the assets required for normal operation becomes increasingly compromised as liabilities outpace assets. The company is becoming increasingly beholden to its lenders.

Step 4 – Increased borrowing

Instead of tackling the twin problems of low trading stability and consequently profitability, a business that makes it to step 4 often rebuilds or maintains working capital through increased borrowing.

The company will tend to shift short-term, high-interest debt onto longer-term liabilities with more favourable payment terms. The hope is the marginally lower repayment terms will improve cash flow. However, the overall level of debt relative to assets remains the same. The increased lending has been used to refinance debt rather than invest in additional assets for the furtherance of the business.

The best alternative to turn any business around that reaches step 4 is a fresh injection of shareholders’ funds. Rather than taking on further external debt, new shareholder capital will stabilize the business and buys the required time to recalibrate the business.

Step 5 – Further decline in profit

Businesses that traverse through to step 5 eventually see their compromised profit margins further diminished, often eliminated, as interest payments bite. This is particularly in this new era of more expensive refinancing costs. The business is left vulnerable to nervous lenders or suppliers pulling support or any turbulence in trading conditions, to trigger its collapse.

Of course, the Board of any failed business will blame external factors. However, in all cases, the Board had ample opportunities to monitor and address the warning signs, get the company back to generating sales and profits commensurate with investments and focus on business longevity.

Some companies at this late stage will be rescued in a takeover and subsumed into a larger group. Few ever regain their former glories. Most businesses at step 5 sadly fail.

Plimsoll believes that business failure can be avoided if you heed the early warnings offered up by the Plimsoll Model. Our graphical predictor of company failure (and strength) is designed to show any business leader, even the non-accountant when their business is failing to generate the requisite growth and profit, when liabilities are outgrowing assets and when the future of your business is at risk.

What is more, the platform Plimsoll delivers its analysis by allowing you to form the same opinion on every competitor, supplier, customer, or trading partner you have. Spotting weakness and warning signs of failure in the companies important to your long-term success is key to beating your rivals, avoiding picking bad trading partners and being caught out by otherwise surprise failures.

At Plimsoll, we believe these warning signs should be constantly available, always up to the minute and always easy to digest. We do the analysis; you take the relevant actions.

For a demonstration of the Plimsoll Model or to learn more about our range of analytical platforms, please call us on 01642 626400 or click here to request a callback.