“Entrepreneurs believe that profit is what matters most… But profit is secondary. Cash flow matters most.” – Peter Drucker
Cash is truly the lifeblood of your business. Without it, there’s no money to hire employees, buy supplies, or repay debt. According to a US Bank study, 82% of businesses that fail do so because of cash flow problems. Don’t be a statistic- learn six cash flow mistakes that can sink your business, and how to avoid them.
1 | Overestimating Sales
If you have a financial plan for your business that projects your income, expenses, and expected profit, congratulations! You’re on the right track. However, if your sales projections are overly optimistic, you may find yourself short on cash. If you’re counting on every one of those sales to materialize in order to afford your business expenses, take a step back. Most businesses don’t generate significant sales in their first few months (or sometimes years) of operation.
While it’s great to have a “best case scenario” financial plan for your business, it’s also important to have a more conservative backup plan. Identify expenses that you can reduce, postpone, or eliminate if sales aren’t as strong as you expected, and immediately cut costs when needed.
2 | Overdue Customer Invoices
You’ve made the sale and sent the invoice… now you need your customers to pay you on time so you can pay your own business expenses.
To avoid coming up short, review your accounts receivable (A/R) aging report each month and contact customers that have overdue invoices. Include consequences such as late payment fees in all your customer contracts, such as 3% of the invoiced amount for each month that the invoice remains unpaid. Set clear collections policies for unpaid invoices and be diligent about following up.
3 | Out of Sync Payment Terms
If the payment terms you offer your customers are significantly different than those you have with your vendors, you’ll quickly wind up with a cash flow deficit. For example, if you give your customers 45 days to pay your invoices but your vendors require you to pay in 15 days, you’ll need extra cash on hand to cover the 30-day gap in payment terms.
To close the gap, renegotiate your contracts with customers and vendors. If that’s not possible, consider offering your customers a small early payment discount, typically 1 – 3%, to give them an incentive to pay invoices before they’re due.
If out of sync payment terms are a consistent problem, invoice factoring may be a solution. Factoring companies advance qualified businesses short-term cash secured by the value of customer invoices. Here’s how it works: You send your customer an invoice for $25,000 that’s due in 60 days. The factoring company advances you $25,000 immediately, and then collects payment from your customer when it’s due. As with any type of financing, be sure you fully understand the costs of the factoring arrangement. Factoring companies generally offer their services in exchange for a percentage of the invoice value.
4 | Not Having a Cash Flow Forecast
When you first started your business, managing cash flow may have seemed as simple as ensuring you had enough money in your bank account to cover your expenses. But a bank account balance is simply a snapshot in time that doesn’t provide insight into how much cash you’ll have in the future.
The solution is a cash flow forecast that predicts future inflows and outflows of cash. By looking ahead, you’ll eliminate the much of the uncertainty about the cash you’ll have on hand next month or six months from now. You’ll be able to pinpoint times when you expect a cash flow deficit and create a plan to ensure it doesn’t put your business in jeopardy.
5 | Not Having a Backup Plan
Cash crunches are sometimes inevitable. It’s impossible to predict the future with perfect accuracy, so it’s crucial to have a cash cushion or “emergency fund” to fall back on when you have a cash deficit. Your emergency fund should include enough cash to fund at least 3 months’ worth of operating expenses. Keep the funds in an account that isn’t at risk of losing value, such as a savings account.
You can also consider applying for a line of credit that you can draw from when your cash flow forecast indicates that there will be a deficit. Interest rates for lines of credit are variable, so stay on top of your borrowing costs by reviewing your monthly statements.
6 | Not Knowing Your Numbers
Last but not least, you must know your numbers to have positive cash flow and a profitable business. It’s tempting to put managing your finances on the back burner while you focus on generating the revenue needed to sustain your business. But without a solid understanding of your monthly financial performance, it’s difficult to pinpoint problems and determine how to adjust course when things don’t go as planned.
Each month, review your cash flow statement, which reflects your inflows and outflows of cash, and your P&L, which details your income, expenses, and resulting profit or loss. Those two reports will give you an understanding of your sources and uses of cash.
Maintaining healthy cash flow is a common challenge for entrepreneurs. If you stay on top of your finances and regularly update your cash flow forecast, you’ll set yourself up for future success. If you have a cash flow problem and aren’t sure what to do next, make it a priority to engage a qualified financial professional. When you have little cash to begin with, it may seem counterproductive to spend more of it. But just as a doctor helps you get well when you’re sick, an experienced CFO can help your business return to financial health. Engage a CFO today. Your bank account will thank you!
About Momentum CFO
Momentum CFO is a boutique firm specializing in outsourced Chief Financial Officer services for small to mid-size businesses. We bring the benefits of Fortune 500 financial expertise to your business without the expense of hiring a full-time CFO.