Business Failure: How to avoid business failure


A few weeks ago, we spoke about a business that was in distress. That business failed and folded. As it happens, the business owners spent many months in denial and lies. They asked for help and advice from everyone they knew, including this columnist, and then went belly-up as it was too late.

Let me summarise the situation. A young couple began a trading business, in which they sourced and distributed electronic security systems for institutions and corporates. They grew their clientele quite well over five years. They also got larger orders from semi-government organisations. Then they became stuck with payments to suppliers, which was when they got in touch with me. In the earlier column, I had written about choices for a small business needing working capital (
How to run a small business).

Now it turns out that they have loans from several friends and relatives, as well as a large outstanding loan from a local NBFC. They do not have enough money to cover these loans. The parents have now become involved, as also a close set of near relatives and friends. They want to know what is the way ahead. It is unfortunate, but responses to my earlier column tell me that this problem is more common than I had imagined.

An independent accounting of all assets and liabilities will have to be done. Without knowing what is owned and owed, we cannot take the next steps. The jewellery has long been pawned; investments in a few deposits and mutual funds have been liquidated; there is now talk of the house being mortgaged. That is a red flag. If the house they are living in is being considered for mortgage, it might actually mean there are no other assets to liquidate. It is also known that they have taken hand loans from many people. Small amounts that add up to a lot even without interest. The loan from the NBFC is not against invoices, but a personal loan at a high interest. The unravelling of the crisis has come about as collecting agents have appeared at the door. A friendly CA or a trusted friend or relative must make a complete list of all loans, using bank statements, phone and message records, and conversations with the couple.

In a small business run as a sole proprietorship, there is no segregating personal assets from business assets. If it is known that the assets are worth more than the liabilities, they have to liquidate and pay. There is no scope to seek any bankruptcy protection unless liabilities are higher. Without numbers, there is no way to write a plan for clearing this mess and starting over.

How to run a small business

How to run a small business

There is no point seeking further loans to repay what has been borrowed. Without any income to pay off a loan, taking a loan only lines the lenders’ pockets as assets will be liquidated to meet overdue balances. The family has no income other than a small government pension that might cover the basic expenses of the household.

Seeking interest-free loans from friends and well-wishers will create a needlessly easy exit for the offenders who took loans. It turns out that the young couple did not differentiate between revenue and profit. When large sums began to flow in revenue, they began spending it on a luxurious lifestyle. They seemed confident somehow that as sales rolled, they would make up for the money they took out of the business.

After getting used to the ostentatious lifestyle, they began to borrow. Outsiders thought that the business was doing very well. The immediate family remained very impressed with the ‘progress’ of the couple. They did no strategic analysis of their working capital needs or funding requirements. Instead, they kept dipping into the revenue that the business generated and felt satisfied with the inflow from time to time. They took loans when they could not match the cash flow. What has been spent recklessly will have to be repaid painfully. Bailing them out will only perpetuate their reckless behaviour.

If all they have is a house, they should sell it, even if it is a distress sale, repay all their loans, downgrade to a more modest house, and start over. They can also choose to invest the sale proceeds sensibly in wellmanaged financial instruments to generate income for the household, and stay on rent until they can find another job and a stable income.

Not having accounts and records is a poor way to build a business. The CA who files their income tax returns admitted that they hardly provided him with adequate information to do his work truthfully. Since the filing was of individual returns and the annual business revenue did not cross the minimum limit for audited accounts and return, the show continued. The GST account was poorly maintained. The bank accounts were all merged between personal and business transactions.

Many think that business dealings of these kind are a ‘smart’ way to evade taxes. It is not just criminal, but also foolhardy. When a business has proper accounts, control is better. The owners who think top-line revenue is bottomline profit, are extremely poor managers of money. When they needed a loan, they could have raised it at lower rates from their bank as an overdraft, or from an NBFC discounting their invoices, or by taking loans against assets instead of liquidating them. The rates would have been lower.

They could have charged many business expenses to their business income and planned their taxes effectively. With poor records, they suffered more than they may have gained by evading the taxes. The money they drew was spent. If it had been used to acquire assets, they would have had a fall-back. Farmers with uncertain incomes bought livestock and gold when harvests were sold. These assets were traded in lean months to keep the family in comfort. Many new businessmen do not see the merits of having assets that can be quickly traded. Buying jewellery is not a great idea if it is never sold or if it is pawned and lost in distress.

Their business failure shows how some first generation entrepreneurs do not give financial strategy, funding, capital estimation, accounting and taxation the importance these deserve. Being reckless is also crooked and costly, and there is nothing innocent and naive about it, as the parents would have me believe.

(The Author is CHAIRPERSON, CENTRE FOR INVESTMENT EDUCATION AND LEARNING.)



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