Why do most businesses fail? One of the leading causes has likely been beaten into your head since your high school economics classes: Insufficient capitalization. Or, to be more specific, inadequate cash flow or cash reserves.
However, it’s a lot more complex (and important) an issue than simply not having enough cash on hand to pay your bills or see the company through a rough spot of lower income. “Running out of money” is usually the result of several factors which have occurred over time and were ignored or not well understood.
You’ve probably heard the old adage from Ernest Hemingway’s “The Sun Also Rises”, and variously attributed to Mark Twain and F. Scott Fitzgerald, that there are two ways to go broke: “Gradually, and then suddenly.” Not surprisingly, that’s how many businesses go bankrupt. First, they deplete their cash reserves, eat through the owner’s savings, and finally, completely tap out their credit lines. Then, in a flash, it’s over.
Managing a successful business boils down to two basic skills which unfortunately are too often overlooked in the hustle and bustle of keeping all the other plates spinning smoothly:
The widespread lack of awareness of the importance of cash flow management, especially among smaller, closely held businesses, has been driven home to me over and over as a financial planner. Following my speaking engagements or when meeting with a client for the first time I hear the same comments repeatedly:
“I don’t need to understand accounting, I have a bookkeeper/accountant doing that for me.”
“At the end of each month I see how much is in the bank and I keep score that way.”
“Numbers/mathematics has never been my strong suit, I’m an entrepreneur.”
“As long as I can see that I’m making a profit, I figure the rest will work itself out.”
Without sounding punitive, I can state definitively that each of these statements are huge red flags that the business in question may be in serious jeopardy. The unfortunate truth is that of those that fail, many will do so for completely unnecessary reasons.
Here are some cash flow rules which can help you avoid being in the dark about your finances and improve your chances for long-term success:
Also known as a profit and loss statement, your accountant should be providing you with this summary of your profit or loss on a monthly, tri-monthly/quarterly, and annual basis. Because the income statement encapsulates all revenues and operating expenses in a clear and concise manner, it enables you to determine the overall financial performance of your business. Out of control costs, sources of highest margin revenues, unexpected or unnecessary expenditures, and many other key factors come into sharp focus when this report is formatted properly for your needs. In addition to making you a better-informed manager, your income statements along with your balance sheets are essential information for securing business loans and lines of credit with banks, vendors and prospective investors.
Regardless of your capitalization, building a solid cash flow is better accomplished with clients who pay reliably and on-time as opposed to customers who stretch out payments, ask for longer terms, or may default on their accounts, even if they place larger or higher margin orders. Pay close attention to your payment terms and be selective to whom you provide credit so they won’t expose you to undue risk. Invoice promptly and clearly state terms and acceptable payment methods. Keep on top of delinquent accounts. Being able to pay with credit/debit cards or online encourages faster payment and gets money into your account almost immediately.
Just as the income statement documents all recent financials, the continual use of a cash flow forecast provides visibility into the immediate and longer term future. Calculating and revising cash flow on a weekly, monthly or even daily basis, if you’re so inclined, serves as your crystal ball for seeing what’s around the corner. Creating such a forecast is relatively straightforward and should be updated monthly on a rolling 12-month basis. Using a spreadsheet with 12 columns representing months of the year, enter the following data: Operating Cash (Beginning),
Sources of Cash (receivables), Total Sources of Cash (Operating Cash added to Sources of Cash), Expenses (uses of cash), Total Uses of Cash (all expenses combined from each month),
Excess (or Deficit) of Cash (all Uses of Cash subtracted from Operating Cash). By tracking this diligently and accurately, you’ll see precisely when and how much you have in either profits or deficits on an ongoing monthly basis.
Understanding expenses is crucial to profitability. For example, as you focus more intently on the outflow of your cash you’ll become better equipped to reduce costs and directly and favorably increase bottom line profit, a key factor in protecting the health of your company and providing expansion capital. There’s considerable truth to the well-worn expression that “a penny saved is a penny earned.”
Among the benefits of the cash flow forecast is its ability to help you identify shortfalls in cash balances before they occur. The trust you have established with your suppliers and creditors is a valuable asset and one you must take every precaution to preserve. If you anticipate a cash shortfall, ask for extended credit terms well in advance to make it clear you have good financial controls in place and therefore less of a credit risk. By identifying slow pay customers or changes in payment patterns early, you can reduce the odds of uncollectable accounts which can wreak havoc with cash flow. Many debtor problems can be avoided by being selective in extending credit terms and thoroughly checking references and credit reporting agency data. Prompt and professional communication with customers heading toward default can dramatically increase your collection rate.
How effectively you finance your working capital has a direct impact on your ability to strengthen your business’ finances and underwrite growth. Many business experts and accountants divide working capital accordingly: temporary working capital and permanent working capital, depending on where the money originates. The financing of working capital typically falls into three categories; spontaneous or readily available, short term, and long term. There is a wide spectrum of financing options available to any business with receivables and at least a two- or three-year history documented in bank statements. You probably already have a personal relationship with a manager or business loan specialist at a local or regional bank or credit union. In addition to overdraft protection on your business account you can expand your reliance on this source of ready capital as needed. Loans secured by business assets and/or receivables can be a useful resource but the monthly payments and fees can put significant strain on your overhead unless they are paid down promptly. Business and personal credit cards are also convenient and practical methods of payment for inventory, equipment and sudden expenses, provided you keep balances low and they offer competitive interest rates. Many businesses lease equipment such as machinery, vehicles or furniture to avoid large capital outlays and to reduce taxable income. Company-owned assets including real estate can be sold and leased back with similar benefits.
Your choice of accounting firm or CPA professional may be the most strategically important relationship in the lifecycle of your business. Rather than consider “the books” to be a monthly or quarterly interaction with those who keep them, you will gain immeasurable insight by considering them a partner in your success. An experienced and top notch accountant will be familiar with all the strategies outlined in this article. Moreover, they should be fully qualified to implement them and use them to the best tax reporting advantage for your firm. Ultimately, best practices accounting is what cash flow management is all about.
In addition to having a superstar accountant in your corner (if you look hard enough, you’ll find one), you should consider speaking with an independent wealth management firm. Just as your business requires expert oversight of its financials to maximize opportunity, your personal wealth and family’s future deserves nothing less than insightful guidance of the growth and protection of the assets you’ve worked so hard to accumulate. The number one reason why an owner won’t sell their business to enjoy retirement is due to lack of cash flow. An initial consultation should be an in-depth and frank discussion of your current situation and your immediate and long-term goals, both of which will start the conversation toward creating a wealth management game plan tailored to your needs.
As you have gathered from this brief article, there are many tried and true tools and strategies that can help you monitor and manage cash flow. However, consider this simply a primer on the topic and a springboard for your continued research on your journey as an entrepreneur and business owner.