What causes SMEs to fail in Sri Lanka?

4 January 2016 06:30 pm - 0     - {{hitsCtrl.values.hits}}


It is a global understanding and a duly recognized fact that Small and Medium Enterprises (SMEs) are a major contributing source to emerging economies in terms of economic growth, employment generation, social cohesion and development.

In Sri Lanka, SMEs contribute more than 70 percent to gross domestic product (GDP) and employment generation. Indeed, SMEs contribution to Sri Lanka’s economy is significantly more than in Singapore, Malaysia and Japan. It is therefore important to understand the performance of SMEs given that the failure of this sector would have a significantly adverse impact on the Sri Lankan economy. 

Below table shows us the importance of performance of SMEs to our economy in compared to other countries in terms of employment generation and GDP.

Culture of entrepreneurs in Sri Lanka 
Researches have identified that entrepreneurs are the change agents in economies. In particular, innovative entrepreneurs have become the major contributors towards the economic development of developing countries. Entrepreneurs are part of the population, thus their active social and cultural behavior in terms of integrity, high quality social systems, and decent attitudes affect economic growth of the country.

The Sri Lankan entrepreneur is culturally different from that of a Western entrepreneur. Social power is a key motivator of the Sri Lankan entrepreneur. A research carried out by Ramya Gamage and others of the University of Queensland, Australia suggests that entrepreneurial motivation in Sri Lanka is not entrenched in a need for individual achievement, but in the conscious or unconscious need to satisfy a sense of social intimacy. 

It said, a setting for entrepreneurial motivation is founded through social power, social relations and collectivism. Further they emphasized that consciousness of society and culture, people, environment (socio-economic, political, educational, legal) and entrepreneurial expectations were all integrated in entrepreneurial drive. In my view, the entrepreneurial drive is psychological influenced. There are various reasons, which influence someone to start a business. A survey conducted by Nishantha and Paithrana with seventy-six entrepreneurs suggested that the primary reasons to start a business are to increase revenue, to obtain personal freedom and to secure job security.

A recent study 
I have carried out a specific study with twenty variables (factors) in order to explore why some SMEs failed while some other SMEs are succeeding in similar economic conditions that the failed SMEs operated in Sri Lanka. 

The specific objectives of the study were: (1) to identify the rate of business failure among SMEs in Sri Lanka, (2) to identify the causes of business failure among SMEs in Sri Lanka, (3) to identify the differences in the causes of business failure and success and (4) to compare whether previously-recognized factors of business failure in other studies are relevant to the business failures in SMEs in Sri Lanka.

What is business failure and success? 
Various people have defined business failure in various ways. Studies had recognized business failure upon its exit, bankruptcy, and liquidation. However some other scholars have recognized the business failure through its business-underperformance. Consequently, business failure was defined under three parameters for this study. These parameters are, a business that was having (1) continuous losses, (2) severe working capital problems and (3) closed businesses. Similarly opposite results of the above parameters helped to recognize successful SMEs.

What is SME? 
Similarly, SME has numerous definitions in diverse studies. Having obtained a basis from those definitions, SME was defined for this study as a business that has less than 250 employees. For this study, only private limited companies were taken into consideration. 

Data from 450 respondents (450 SMEs) were used for the analysis. From these data, 250 businesses were recognized as success SMEs while recognizing 200 businesses as failed SMEs. Table 2 shows the number of failed and success SMEs under the respective size of the business.

Once the data was collected, business failure has been further analyzed in line with the above business failure parameters. It was found that the highest number of failed SMEs among 450 SMEs had both continues losses and liquidity problems. As per the below table it was 16 percent with 74 SMEs.

Of those failed firms, 30 SMEs responded that they have continues losses, that is 15 percent. Similarly, 46 SMEs said that they have severe liquidity problem that is 23 percent. Completely closed businesses take 25 percent of failed SMEs. 

The findings of the study indicate the following. The rate of business failure among SMEs is 45 percent. Further, the findings of the study showed that seven variables are significant in explaining business failure in Sri Lanka. These variables are: business planning, record keeping, issuing postdated cheques, budgetary controls, staff quality, basis of recruitment, and commitment of owners for business management.

It shows that these variables (causes) fall into few broader areas of business such as lack of prior business planning, lack of up to date reliable accounting data, inappropriate financial, and human capital management, and inadequate commitment of owners for business management. 

The magnitudes of the effects of these variables were calculated with odds ratios. Commitment of owners takes the highest odds ratio, which is 14 times. It means that possibility of a business failing due to lack of owners’ commitment is 14 times compared to a business that has adequate owner commitment.
Among others, analysis also showed that the level of education of business owners, prior business and managerial experience, marketing knowledge and skills, and startup capital are also important in influencing business failure. In addition, it has revealed that there is a significant difference between SMEs that have failed and those that have succeeded in relation to these significant variables. It showed that the percentage of business success is substantially high given that those variables were substantially addressed in the business. 

The results of this study were further compared with other similar studies to gauge the relevance of the variables identified for Sri Lanka. The results showed that these variables also largely accounts for the business failure in other countries. However, the variable ‘commitment of owners’ was not tested in other studies in other countries; it is a significant factor influencing business failure in Sri Lanka. Therefore, it could be considered as a country-specific variable to Sri Lanka.

In conclusion, business failure in SMEs in Sri Lanka is 45 percent. And also seven factors are found to be significant in explaining business failure in Sri Lanka. In other words, in order to establish a successful business, there should be prior business planning, and having up to date reliable accounting data, effective financial, and human capital management practices, and adequate commitment of owners for business management. However, a business could be failed due to one particular factor or due to impact from several factors. Hence this study recognizes only common reasons for business failure in Sri Lanka, but there may be various other reasons of business failure, which will be specific to those failed businesses. For an example, findings of the past studies contended that some businesses have failed due to business expansion, disputes among business partners, inventory management issues, economic recessions etc…Nevertheless, fundamental business management principles such as proper business planning, effectiveness in financial management, live recording of accounting data, effectiveness in human capital management, and your own commitment for business management are basics of good foundation for business success. In addition, as per the past studies in the world, lack of prior business and management experience, inadequate startup capital, lack of marketing skills and knowledge were also contributing source to business failure.

As an overall recommendation, the government should consider the importance of understanding SMEs failure and provide business support systems in terms of business planning and monitoring as a matter of priority. In this context, this study suggests the government should consider centralizing various fragmented agencies and institutions, which were established for SMEs to one organization in order to encourage business start ups, provide advisory services to small businesses and finally to minimize number of business failures in Sri Lanka.

(Dr.Chamara Bandara is a senior Chartered Accountant with more than 10 years of experience. He is the founder of Corporate Doctors (Pvt) Ltd and 
SCB Corporate)

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