Running out of cash is probably the biggest cause of small business failures. Numerous factors can provoke a cash crisis, so it's crucial to be able to recognize them and know how to keep a short-term problem from exploding into a catastrophe. While physical assets and receivables may make your balance sheet look strong, it's your ability to turn them into hard cash at critical times that can mean the difference between survival and failure. Some of the main causes of cash flow problems and ways to overcome them are addressed below.
Slow-paying customers are a main cause of cash flow problems. Remember: a sale is not complete until your invoice has been paid in full. Too many businesses concentrate on generating new sales but fail to set up credit-control procedures until cash flow problems begin to appear. By then, it's too late. Such procedures should be in place from the start.
A key customer becoming insolvent is another common cause of cash flow woes. A business that depends heavily on a few major customers is always exposed to a major risk: If just one customer suffers its own financial problems, they can become your problems if you don't get paid. Such problems can quickly spiral into disaster if the customer represents a big chunk of your overall revenue, for you're apt to be relying on that revenue to meet your payroll or pay your creditors.
Poor financial planning can cause wrenching problems. Your business must plan for certain payments, such as payroll expenses, various taxes, loan payments, payments to key suppliers—the list can be endless. You need to incorporate these payments into your cash flow forecasts and then make sure that sufficient funds will be available at those key times. Also make sure that any purchases of equipment are scheduled when your cash position is stronger or are structured over a longer time frame to reduce the impact on your cash flow.
A business plan that focuses only on sales revenue and neglects profit is a second way to trigger a cash flow crisis. Essentially, a business generates a positive cash flow by earning profits from its operations. If your sole focus is revenues, you may improve sales—but you might also wind up spending more dollars than your business generates; that's negative cash flow. It's a problem that can become acute if a business has to invest in new equipment and staff as it grows, because a company often incurs these costs long before they can begin contributing additional sales revenue.
A third common cause of cash flow problems is poor inventory planning and ill-considered purchasing. It's indeed tempting to stock your shelves, especially if suppliers offer fat discount incentives to purchase larger quantities of goods. At first glance, such offers look very attractive, because they hold the promise of larger profits. But take a second look; you need to think carefully before committing to large orders, particularly during your business's early development period. If you order bulk purchases of goods that quickly go out of fashion, or have a short shelf life, you're left with stock that cannot be sold—but stock that you still have to pay for.
Dramatically, if growth is slow or non-existent! That leads to insufficient working capital, still another common cause of cash flow troubles. In other words, there wasn't enough money initially invested in the business to enable it to operate effectively on a daily or weekly basis. A business that is growing rapidly and trying to produce at maximum levels without having the income to fund its growth also risks winding up with too little cash. The British call it "over-trading." Wall Street might call it "dangerously ambitious spending." It's important to keep your cash flow healthy.
There's simply no substitute for carefully—and perhaps cautiously—preparing a cash flow forecast and the alternative plans of action that it suggests. The forecast helps identify and anticipate most cash flow problems that could occur during the normal course of running your business. It also allows you to create different cash flow scenarios: Each one allows you to see the effect of various sales levels or slower payment cycles. It's an exercise that will help you know in advance what strains might confront your business, if things do get tight, so you can plan how to overcome them.
Tight credit-control procedures are an absolute must, so make them your priority. Start by only giving credit to approved customers (whose references you've checked out). Keep an eye on when their accounts are due to be paid and make sure that they pay according to your agreed terms. It's a good idea to confirm in writing any deals you arrange, so customers can't claim that they didn't really understand what the payment system was. Also make sure that you have efficient procedures for promptly submitting invoices to your customers. Basically, the sooner you invoice, the sooner you'll get paid!
Offering incentives for early payment is another good way to encourage customers to pay more quickly. You could do this by offering a discount if they either pay on delivery or within a certain number of days from the invoice date (typically between 7 and 14 days). Typical discounts range between two and five percent, but the exact level will depend on your profit margins and on how important early payment is to you. It's probably wise to offer such discounts only for a limited period; otherwise customers will begin to expect them. That can weaken your business in the long term.
As your business grows, aim to negotiate better credit terms with your suppliers. For instance, shift from paying suppliers at the time of purchase to having 30-day credit accounts. Or, if the majority of your customers expect to have 60-day credit accounts, try to arrange 60-day payment terms with your suppliers. Such consistency should help cash flow.
You can work with a bank via a line of credit. You may, however, outgrow this. Debtor finance is a common option for businesses growing rapidly, and you could investigate using the services of an invoice-discounting firm. These companies arrange to provide your business with an advance, usually 80 percent, on the value of your invoices, as soon as these invoices are submitted to customers. Interest is then charged on the balance drawn, and there is a service charge. Discounter firms can also be responsible for collecting payments from your customers, which can save you the costs and hassles of using your own staff to manage collections.
An agreed overdraft facility with your bank allows you to borrow money as required up to an agreed limit. It is a relatively cheap way to finance working capital if you have large variations in cash flow during a given month or if your business is very seasonal, since you only pay interest on the dollars you actually borrow. However, relying continually on borrowed money can be expensive; more importantly, it may also indicate that your business needs additional working capital or longer-term financing. Overdraft plans also expose a business to repayment on demand, which means that your lender can ask for full repayment at any time. A term loan with fixed monthly installments is a safer financing option, because the lender usually can demand full repayment only if you default on your installments.
If your business needs to invest in new equipment, but does not have the cash, then you can turn to asset financing, such as a term loan, a hire-purchase loan, or a leasing deal. This avoids paying for the equipment with a large lump sum of cash and gives you a fixed level of repayment over a set period (usually between two and five years). In situations where a business asset is being used as collateral, it is likely that you will still need to provide at least a 10 percent deposit.
Don't be taken by surprise. Keep a close eye on your bank balance and your financial obligations and continue looking ahead to see what expenditures you will have to make in upcoming weeks. Cash flow problems are best caught early on. The more time you can give yourself to respond, the better.
Don't be fooled into thinking that cash flow problems will resolve themselves; they won't! Alert your bank and your suppliers as soon as you think there might be a problem. Acting quickly will assure them that you are being diligent and doing your homework, even if there are difficult times ahead. If you don't act, you risk jeopardizing your relationship with your bank, suppliers, and customers. Your bank especially will be far more receptive to dealing with your cash flow problems if you approach it before the problem occurs.
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