Causes of business failure

Internal causes

Within the control of managers:

• Poor cash-flow management: no forecast, too much credit given, no overdraft arranged.
• Overestimation of sales: costs and inventory planned for sales that never come.
• Overtrading: growing too fast without enough working capital; the firm takes orders it cannot finance, so it cannot pay suppliers even though sales are rising.
• Poor inventory control: too much (cash tied up, waste) or too little (lost sales).
• Poor marketing: wrong target market, price or promotion.
• Poor quality: complaints, returns and lost reputation.

External causes

Outside the firm's control:

• Market conditions and changing tastes; competition, especially from larger or online rivals.
• Economic conditions: recession, inflation.
• Exchange rates (raising import costs or export prices) and interest rates (raising loan costs and cutting demand).
• Government regulations: new laws raising costs.
• Supplier problems: failure, price rises, late deliveries.
• Natural phenomena: floods, fires, earthquakes, disease outbreaks.

Analysing failure

In an exam, link causes to cash and profit. For example: an interest rate rise increases loan repayments (cash out) and reduces customer spending (cash in), so a business with a high overdraft and weak liquidity is hit twice. Ask which cause was the trigger and which made the business vulnerable, and whether managers could have reduced the risk by planning (cash-flow forecasts, contingency funds, insurance, diversifying suppliers).

Worked example

A furniture maker wins a large contract and doubles output, but closes six months later. Explain how overtrading could cause this.

1. To meet the orders it buys much more timber and hires extra staff, paying cash upfront.
2. The customer pays on 90-day credit, so cash comes in long after it goes out.
3. Working capital runs out; suppliers and wages cannot be paid, and creditors force the business to close despite its full order book.

Answer: Growth without the working capital to fund it.

Check yourself

1. Overtrading means
   • expanding too quickly without enough working capital
   • selling goods at too high a price
   • employing too many staff in a recession
   • trading in too many countries
   Show answer

   expanding too quickly without enough working capital. Rapid growth drains cash before revenue arrives.

2. Which is an external cause of business failure?
   • Poor inventory control
   • Overestimating sales
   • A sharp rise in interest rates
   • Poor quality control
   Show answer

   A sharp rise in interest rates. Interest rates are set outside the firm.

3. Which is an internal cause of business failure?
   • Poor cash-flow management
   • A flood at the factory
   • A new competitor entering the market
   • A recession
   Show answer

   Poor cash-flow management. Managers control how cash is planned.

4. A firm imports most of its materials. Which change could push it towards failure?
   • A rise in the value of its home currency
   • Lower interest rates
   • A competitor leaving the market
   • A fall (depreciation) in the value of its home currency
   Show answer

   A fall (depreciation) in the value of its home currency. A weaker currency makes imports dearer, raising costs.

5. Why can a profitable business still fail?
   • Profits are always taxed at 100%
   • It runs out of cash and cannot pay its debts
   • Profitable firms cannot borrow
   • Profit and cash are the same thing
   Show answer

   It runs out of cash and cannot pay its debts. Insolvency comes from lack of cash.

6. Explain how poor inventory control can contribute to business failure.
   Show answer

   Holding too much inventory ties up cash and leads to waste or obsolete stock, while holding too little causes lost sales and unhappy customers; either way cash flow and profit suffer.. Too much ties up cash and causes waste; too little loses sales.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.