To become a thriving business, a company must consistently meet three metrics: First, you must sell a product or service that the general public desires and needs. Second, your product or service must yield a profit. Thirdly, just because your business issues a profit does not mean you have cash in the bank. Most business owners can manage the first two, but a positive cash flow becomes such a challenge that it’s common for many startup businesses to fail by its third year or sooner. There are sure signs your company is currently struggling to meet its cash obligations, or that it will struggle soon:
1. Growing Overhead
Prestige can get a business in trouble faster than poor sales. Especially for start-ups, business owners want their company to feel modern and successful, and decisions are made from a short-term perspective rather than thinking through the advantages and disadvantageous of every increase to the business’s overhead. Overhead is the term allotted to those fixed expenses that are owed regardless of great or poor sales, seasonal and slow trends, and without care if unexpected situations arise.
A perfect example being office space; there’s certainly nothing wrong with renting suitable office space with comfortable accommodations for your staff and visitors, but did it have to be located on the most renowned street of the city, where rental rates are triple what you could afford? Then keeping in mind that most leases are locked for three to five years, most business owners neglect to perform risk analysis on long-term cash expectations. Instead of leasing a space because of its posh décor, let the deciding factor always benefit the sales and operations of your business. For example, would it be best to be located closer to your warehouse? Where do your customers spend the majority of their time? Is it better to be accessible to public transportation? Is security vital to your organization?
Likewise with increasing your staff head count, especially towards staff that do not typically influence your sales or provide business advice—such as IT, Administrators, Compliance Accountants, and duplicated Executives (Senior Vice President of Finance along with Director of Accounting, accompanied with a Controller). When you add to your staff, you increase as well your tax liability, the need for increased office space and resources, and all offered benefits and perks, such as health insurance and reserved parking expenses.
Never give a non-executive employee the right to increase your overhead, regardless of its simplicity or purpose. Only members abreast on the financial position of the organization should signature agreements and contracts. Common areas of abuse by non-executives are fo software packages, low-salaried staff hired to “help out”, and reoccurring office amenities such as water dispensers and contracted high-end coffee and supplies.
2. A Lack of Business Credit
Most households are wary of credit in an attempt to stay out of debt. A business, however, is not a household nor should not be operated as though it were. If properly managed, business credit can be the life support of a company and can take on many appropriate forms and repayment terms.
- Trade Credit – There are many vendors that will extend goods or services with a future repayment term, for example Net 30 (pay us back in 30 days). Since most businesses need thirty days to receive payments from their own customers, the ability to pay a bill at a later time greatly helps with cash flow.
- Business Credit Card or Business Line of Credit – Often times a business decision is made that demands a larger cash disbursement than current cash flow allow (for example, purchasing an upgraded Customer Relations Database for $30,000). Putting this cost on a credit card, which allows for small monthly payments at $2,000 a month is a relief to a business owner who is sensitive about maintaining a minimum bank account cash balance. There are some managers who insist on charging all company expenses, except salaries and certain transactions, on a business credit card as a cash flow management system and to gain additional perks such as accrued travel points.
The general practice is to have sufficient business credit available, rather its currently utilized or not, rather than desperately needing a loan and having to apply for funds at an inopportune time.
3. Cool Product/Service, but No Profit
You can create the next high-fashioned shoe featured in every magazine and in every celebrity’s closet; but a business owner must show just as much enthusiasm, if not more, for the profit it generates in addition to the styling of the shoe. Many business owners mistaken the true purpose of profit, which is a netted figure that represents the regeneration of future cash. Take a look at this start-up business’s financials, showing wonderful and consistent sales of this same shoe.
|Year 1 Income Statement – Start-Up Business|
|Qtr 1||Qtr 2||Qtr 3||Qtr 4||Year Total|
|Total Cost of Services||(60,000)||(60,000)||(60,000)||(60,000)||(240,000)|
When an accountant or seasoned investor reviews these numbers, however, it’s obvious that this business is in big trouble. Just because there are large sales does not mean you’ve received all of that cash from your customers. Assume that this same business has Net 30 payment terms to their customers, and additional to this, fifty percent of these same customers pay one month late. The company’s cash flow report for that same year will show as follows,
|Year 1 Cash Flow – Beginning Cash Balance of $500,000|
|Qtr 1||Qtr 2||Qtr 3||Qtr 4|
|Beginning Cash in Bank||500,000||433,333||383,333||333,333|
|Payments from customers||33,333||50,000||50,000||50,000|
|Total Cost of Services||(60,000)||(60,000)||(60,000)||(60,000)|
|Ending Cash in Bank||433,333||383,333||333,333||283,333|
If this trend continues, it’s a reasonable assumption that between Qtr 2 and Qtr 3 of Year 2, if something isn’t changed within this operating model, this shoe business will begin to suffer from cash flow delinquencies. Because of this common problem, large and reputable businesses go bankrupt with everyone wondering what happened. Profit equates to future cash flow, and the higher your profit, the more cash you receive to grow your business and issue dividends to your investors.
4. Disastrous Customer Invoice Procedures
The example above shows a particular area that almost always lead to poor business cash flow – improper invoicing. How customers pay for their goods and services is critical to the survival of an organization. Being nice and considerate, or simply picking a payment term is a very erroneous decision. ‘Due Upon Receipt’, ‘Net 10’, ‘Net 30’, and other terms which represent how soon your customers pay determines how quickly your bank account balance increase, and therefore should not be applied lightly. Also, adding consequences such as late fees or a closed account for late payments enforce a check being processed for your business instead of another’s.
Since every company is different, there isn’t a default invoice that fits every business model, but there are simple factors that must be considered before an invoice is sent.
- Unless there’s a specific agreement or contract in place dictating when you should be paid, a good starting place is to set your invoices as ‘Due Upon Receipt’. This term generates the best cash flow position available for any business.
- Make it easy for your customers to pay you. Put all necessary information on your invoice including where to send checks to, how to make a credit card payment, and accompany your invoice with typical customer information requests such as a Purchase Order number, a signed W-9, and any necessary correspondence that provides back-up to their purchase.
- Consistently evaluate who your late-paying customers are and handle them expediently. Keep an open communication as to when they will make payment and why they were late so that the issue will not be repeated. Did you bill them as Due Upon Receipt but the customer has mandatory ‘Net 30’ payment policies you were unaware of? Do they utilize an online portal instead of receiving a physical invoice? Are they struggling with cash themselves—and if so, future sales to them should be monitored.
5. Disastrous Bill-Payment Procedures
The other area for managers to scrutinize is how it pays it bills. Just because you receive checks in the mail every day does not make it wise to disburse checks at that same rate. How you pay your bills must be a strategic and carefully monitored process. Common mistakes made are:
- Un-negotiated bills – Before purchasing goods or services from your vendors, be sure to read the fine print on how they bill, and negotiate where needed in order to receive the best bang for your buck.
- Utilize business credit – As mentioned earlier, charging an expense to a credit card eliminates a quickly decreasing cash flow balance.
- Unreconciled bank accounts and cash reports – Any business that pays bills without understanding the current cash flow position of the organization is making a sore mistake. Before issuing vendor payments, (a) all applicable bank accounts should be reconciled to date so that the manager is aware of the current cash balance, and (b) a cash flow report should be presented so that the full picture of the business’s cash situation is understood in regards to future expected cash receipts from customers along with expected cash disbursements within the coming weeks.
A general rule for success is to pay your bills equal to or less than the frequency that your customers pay you. For example, if you are a Marketing Firm that invoice your customers at the end of each month as Due Upon Receipt, the bulk of your cash will be consistently received the first week of the month. Therefore, your bills should be paid no more than twice a month, with the first check run initiated on the second or third week of the month.
6. A Lack of Financial Reports
Every business owner needs real-time reporting to help make the best decisions that will affect your cash flow. Mandatory Financial Reports impacting your cash position should include at the minimum:
- Income Statement – this report will explain how the company is doing with its sales year-to-date and expose your top expenses. It is important to search for line items that are over-budget or approaching its limits. The driving concern of this report is how much profit are you currently bringing in so that you have an idea how your cash will be reflected in the coming months.
- Balance Sheet – this report is a current snapshot of your assets, liabilities, and equity. You especially want to review your Assets commonly for your reconciled cash balances and any Accounts Receivable balances, as well as your Liabilities as it relates to your credit balances.
- Cash Flow Statement – this report reveals where your cash is coming from—from investments versus sales—and where your cash if primarily going—to your investors or to your business expenses. It’s important to consider the trends of your cash receipts and disbursements.
- Accounts Receivable Aging Report – this report shows all of your current customers and when their balances are due. Remember not to decrease the bank account balance before receiving payment from your customers first.
- Accounts Payable Aging Report – this report show all of your current vendors and when their balances are due. Make sure important invoices haven’t been overlooked, or that you are not paying an invoice before it is due.
This constant stream of information and advice is the purpose of employing an accountant. Recording transactions and filing taxes is one matter, but every business owner needs reliable reporting and a qualified business advisor to keep a watchful-eye on your cash balance. Always anticipate its increase or decrease before it happens—rather than being surprised after the fact.