Just as good cash flow keeps a business afloat, poor cash flow can sink it.
In fact, poor cash flow is a big reason why one in every four businesses doesn’t make it past the first year. And why more than half don’t survive past the fifth.
In this post, I’ll explain what cash flow is, and take you through some of the common cash flow problems and potential solutions that our accounting firm has dealt with over the years.
What Is Cash Flow?
Cash flow is money flowing in and out of a business. It is usually measured over set periods of time such as monthly, quarterly or annually.
1. Disorganized Books
Lots of small business owners put their bookkeeping to one side because they’re so busy with the huge work load of setting up a business.
That’s understandable, but if the books aren’t organized, troubling times lie ahead.
For example, we had a client who was a landscape gardener. He was very good at what he did and charged a fair labor rate. However, he started to fall behind with his bills and received a number of red letters. He came to us with this problem because he couldn’t understand how he was falling behind on payments to suppliers, despite working hard and charging a good rate.
We took a close look at his invoicing system and methods of collecting payment from customers. Some of the problem areas found were: inconsistent invoice numbering, and no proper record of which customers had paid.
We spent time reconciling his overlooked invoices, only to discover significant sums of money had never been received. We then spent time helping him put a good and robust system in place. That meant a strong cash flow and no more red letters.
For most businesses, the only real way to get the books in order is to use an accounting system and to make a point of keeping it up to date.
Once your books are in good order, you’ll be able to stay on top of how much each customer owes you. You and/or your accountant will also be to generate useful reports so that you can understand your cash flow much more easily.
2. Bad Debts
Bad debts are amounts owed by customers that cannot be recovered. They can be crippling for a small business and can easily occur if a proper credit control system is not put in place early on.
A credit control system is the process a business has in place to collect money owed by its customers. We always recommend to clients that their credit control system should be a priority when starting out.
If your business keeps good books then creating a credit control system can be very straightforward. It can be as simple as setting aside a time to send out reminder emails/letters, or become as serious as passing the account to a debt recovery firm.
To reduce the likelihood of bad debts, some of our clients conduct credit checks on their customers before offering them credit. Let’s say you discover a customer with a poor credit record, and you want to take them on as a client. You can ask for a deposit up front or issue partial invoices they can pay as portions of the work completed.
(In fact, this isn’t a bad practice for all your clients, not just the ones with poor credit.)
3. Out-of-Sync Credit Terms
If the credit terms you have set your customers are out of sync with the credit terms set by your suppliers, negative cash flow can build up and worsen over time.
For example, if your customers have 30 days to pay you, but your suppliers want their pay within 14 days, a cash flow problem may build up.
The best solution in this situation would be to renegotiate terms with your customers and/or suppliers. But sometimes this isn’t immediately possible. In cases like these, there are some measures that you can set in motion:
- Factoring: This is where a financial institution lends your business short-term cash that is secured against the value of the invoices you have issued.
- Early Settlement Discounts: You could offer early settlement discounts on your invoices which will give your customers a financial incentive to pay you early. This is typically around a 2-3% reduction in the total invoice value.
4. Profit Problems
Naturally, lack of profit will lead to a lack of cash.
The amount of time it takes a business to run out of cash depends on a number of factors. Ultimately, no business can sustain losses indefinitely.
Businesses with cash reserves from previous profits or cash injections can survive without profit for a while. But a consistent length of time bearing losses will eventually catch up to you, regardless of how small or large your cash reserves.
If your business is losing cash, it’s essential to uncover the cause of any losses and address them as soon as possible. Possible solutions to becoming profitable may be to increase your prices, increase sales or gain better control over your expenditure.
5. Lack of Cash Flow Forecasting
In our opinion, a cash-flow forecast is essential for new businesses. This is something your accountant can create for you.
With a cash flow forecast, you’ll be able to see which months you can expect to see a cash deficit, and which months you can expect a surplus. You’ll also be able to get a pretty good idea of how much cash your business is going to require over the next year or so to survive.
You can gain a lot of insight into your business by comparing actual figures to what you forecasted. If you see discrepancies between the two numbers, dig further to see what might be happening.
For example, if you discover that you are spending twice the amount you thought you were on electricity then you could look at the efficiency of your heating or other areas to save energy. If your telephone bill is much higher than you thought it was, look into the possibility of switching providers for a more competitive rate.
In finding discrepancies, you can adjust your forecasts so they are more accurate going forward.
A cash-flow forecast is also a great resource to help you make important decisions, such as when to make a capital expenditure, or whether or not to cut an expense.
6. Growing Too Quickly
Most people want to grow their business, but sometimes growing too quickly can cause cash flow issues that can hurt the business.
For example, we had a client who had a small IT contracting businesses. He landed a big client who wanted a large project completing within 12 months. In order to fulfill this request, the contractor would have needed an extra 4 members of staff to deliver the project on time.
He immediately took on the extra staff members he needed. When it came to payday, however, he could not cover their wages, as he had not yet received his first payment from the new client.
To fix this kind of problem, you could access a line of credit from the bank, such as an overdraft or short term loan. In many cases, this is a viable option because banks are more willing to lend to a business if they can see a draft service contract or letter of intent.
Once the client pays you, you can pay down your debt. This means that you only have to pay interest to the bank for the amount of time you actually need the cash.
Pay Attention to Avoid These Issues
Small businesses typically face one or more of the above cash flow problems when starting out. Paying close attention to these issues, and developing solutions to keep cash flowing into the business, will ensure your enterprise makes it past its fifth year.
This is an optimized post and was originally published on the FreshBooks blog in February 2016.
about the author
This is a guest post for the FreshBooks blog. FreshBooks is the #1 accounting software in the cloud designed to make billing painless for small businesses and their teams. Today, over 10 million small businesses use FreshBooks to effortlessly send professional looking invoices, organize expenses and track their billable time.