By Samuel D. Bornstein
The important role of small businesses in the stability and health of the United States economy underscores the importance of learning why small businesses fail and what can be done to reduce these failures.
The Federal Reserve Bank’s 1998 Survey of Small Business Finance said there was $700 billion in outstanding debt on the books of small businesses. Of that, $609 billion was in the six traditional types of credit (of which $361 billion was supplied by banks), an additional $86.5 billion represented loans from owners and about $4.8 billion was credit card balances.
Considering the size of this outstanding small-business debt, and the fact that less than 40 percent of new businesses survive for five or more years, we’re talking about real money.
Although there is the Community Reinvestment Act and other federal and state initiatives to extend credit to small business, it appears that credit alone does not guarantee small-business success.
Banks have a lot of skin in this game because of the negative impact when they are forced to write off the resulting bad loans.
In 2004, the FDIC reported that net loan and lease charge-offs after recoveries were more than $29 billion.
The banking community should be playing a pivotal role in efforts to address small- business failure. Even partial success will mean great savings, both in money and the health and well-being of our community.
There are some initiatives that can help. Small business owners should learn to analyze accounting and financial data. One antidote to small-business failure is the knowledge and understanding of practical accounting and its analytical tools and techniques (financial ratios). These can help diagnose the health of a small-business, and show the business owner where the business has been, where it is and where it is going financially.
There is strong research evidence that failures can be predicted and businesses can be saved from failure if their problems can be detected in time.
The predictive ability of financial ratios depends on accurate and reliable accounting data. Small-business owners can be taught to understand and use these accounting principles to create financial statements. These statements can then be used to generate the financial ratio analysis to provide an early warning system, predicting and correcting problems before they damage the business.
To the average small-business borrower, improved management is very nearly as important as financial aid. Studies have indicated that nearly 90 percent of failures are due to inadequate management. Most small- business owners know how to produce the product or deliver the service they’re offering, but they simply may not know how to run a business and make a profit.
Failed firms share some common characteristics that fall into key groups:
• Management’s personal financial shortcomings (no accounting background, cash flow analysis, financial records, etc.);
• Decision-based characteristics (lack of insight, inflexibility, emphasis on technical skills, etc.); and
• Managerial deficiencies (lack of management skills and appropriate managerial training, etc.).
One survey found that lack of management expertise and financial-related factors were most commonly cited as reasons that existing firms failed. A 1983 paper by Wichmann reported that accounting and management capabilities were important attributes affecting small-business success and failure.
Information gained from financial ratio analysis can be used as an early warning indicator of business failure. In fact, the trend toward failure can be detected within the critical first five years and, once determined, corrective action can be taken. Companies with weak and unstable financial ratios are more likely to fail than companies with stronger and more stable financial ratios.
The predictive ability of accounting data has been recognized by researchers for many years. Well-known research has established a statistically significant predictive relationship between financial ratios and specified business phenomena, such as bankruptcy, business failure and long-term credit standing.
Just as an individual’s health can be monitored through blood tests, electrocardiograms, blood pressure readings and so on, a business requires its own unique health measurement mechanisms to monitor its survival, profit and growth.
Trends in liquidity, efficiency and profitability ratios may be more significant than actual sales and profit figures. Financial ratios can be compared to average industry ratios for comparably sized businesses.
Small-business owners often neglect financial analysis of their firms’ performance because of the daily demands of running the business. The owner is wearing five hats, there may not be a chief financial officer and an outside accountant may be acting as operations manager. Small-business owners often rely on their bankers to substitute for a chief financial officer. After all, most bankers are business consultants who happen to lend money as well. Financial ratio analysis is not considered an important service because the business owner is often not willing to pay the extra fees involved. Therefore, this vital aspect of small-business management is often ignored by both the certified public accountant, as well as the small-business owner.
The banking community can provide a valuable service to the U.S. economy by helping small-business owners understand the link between accounting functions and the predictive ability of the financial ratios.
The information generated by financial ratios can help diagnose business health and identify areas of weakness in time for corrective action. Bankers who focus their small- business clients on this linkage will provide both a competitive “value add” to their clients and a useful service to the community that promotes sustainable growth and economic development.
Samuel D. Bornstein is a certified public accountant and managing partner at Bornstein & Song. His practical CPA and consulting experience is paralleled by his 29-year teaching role where he has been a professor of accounting and taxation at Kean University School of Business in Union. He can be reached by phone at (732) 493-3399 or via e-mail at firstname.lastname@example.org.