Good cash flow keeps a business alive, poor cash flow can sink it. Poor cash flow is a big reason why 20% of businesses doesn’t make it past the first year, and why more than half don’t survive past the fifth. This post, will explain what cash flow is, 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.
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Disorganized books
Lots of new 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, it will inevitably cause trouble down line. For example, Bob a landscape gardener. He was very good at what he does and charges a good labour rate.
However, he started to fall behind with his bills and started to receive lots of red letters. Bob couldn’t understand how he worked so hard, charged a good rate, he still fell behind on payments to suppliers. A closer look at his invoicing system and methods of collecting payment from customers revealed all. We discovered problem areas such as in inconsistent invoice numbering and no proper record of which customers had paid. Bob spent time reconciling his invoices which led him to discover a significant amount of money was owed to him but had been overlooked. Bob spent time putting a good and robust system in place. This means he now has good 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 like aged debtor and creditor reports so that you can understand your cash flow much more easily. With mobile technology, you are able to keep your books up to date wherever you are. Bob does it while sitting in his car and invoices his clients when he is there. They receive the invoice via email instantly. Both Bob and his clients are happy because they both know exactly how much money is owed.
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Bad debts
Bad debts are amounts owed by customers that cannot be recovered. They can be a crippling for a new business and can easily occur if a poor or no credit control system is not put in place early on. A credit control system is the money collecting system. A credit control system should be a priority when starting out. If your business keeps good books then creating an effective credit control system can be very straight forward. Regularly setting aside time to send out reminder letters/emails to their customers, or to take more serious action such as passing the account to a debt recovery firm is the only way to stay on top of things and therefore keep your business going with the cash coming in.
To reduce the likelihood of bad debts, some businesses conduct credit checks on their customers before offering them credit. If 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 are completed. Just because their credit record is not 100% perfect, does not mean you cannot have them as a customer. It means that you have to take precautions to ensure you do not work for free. Remember, they might be a small business just like – trying to make it through every month while building up their cash flow. Business is about relationships too. Go and visit the business owner and talk to them and establish that relationship. This can only help you both.
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Pay Before Paid
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 which will get worse over time. For example, if your customers have 30 days to pay you but your suppliers want to be paid within 14 days then a cash flow problem may build up.
The best solution in this situation would be to renegotiate terms with your customers and/or suppliers. However, if this is not possible straight away, maybe because you have written agreements in place already, then there are some temporary measures that you could look at:
- Factoring: This is where a financial institution will lend the 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.
Both of the above options will incur charges or create expenses. These should ALWAYS be taken into careful consideration before making any decision. Always try for the best possible solutions first.
- Profit problems
A lack of profit will eventually 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 but no business can sustain losses indefinitely. For example it is possible for a business to survive for a while if it has cash reserves, possibly from previous profits or cash injections such as bank loans. However if a business consistently makes losses then the cash reserves will eventually deplete and the business will fail.
You are in business to make a profit so you have make sure that you charging the correct amounts in order to make that much needed profit. Some industries have very tight (small) profit margins, as little as 2% whereas some industries have variable profit margins (as much as 100%).
Profit margins can also be determined by outside regulatory bodies such as government or banks. Here in South Africa, petrol is one of these items. The petrol price is fixed so the profit margin will be fixed at a certain percentage. It’s a very simple calculation. The petrol station buys the petrol at a certain price and sells it at a certain price. The profit is the difference.
If your business is losing cash, you must uncover the cause of any losses. 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.
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Cash flow forecasting
In our opinion, a cash-flow forecast is essential for new businesses. This is something an (preferably yours) 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 (more expenses than income), and which months you can expect a cash surplus (more income than expenses). You will get a good idea of how much cash your business is going to require to survive over the coming next year or so.
You can learn a lot about your business by comparing actual figures to what you forecasted. If you see discrepancies between the two numbers, you 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 as expected. Look at the efficiency of your heating or other areas to save energy. If your telephone bill is much higher, look into the possibility of switching providers for a more competitive rate.
When discrepancies are found, 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. This includes when to make a capital expenditure (buy assets or etc), or whether or not to cut an expense.
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Too Much Too Soon
Most people want to grow their business, but sometimes growing too quickly can cause cash flow issues and these cash flow issues can hurt the business. For example, Bob has a small IT contracting businesses. He landed a big client who wanted a large project completed within 12 months. In order to fulfil this request Bob would have needed an extra 4 members of staff to deliver the project on time. No brainer right, so Bob immediately took on the extra staff members he needed but when it came to pay day he could not cover their wages as he had not received his first payment from the new client yet.
To fix this kind of problem, you could access a line of credit from a bank. This may be an overdraft or short term loan. 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 you pay interest to the bank for the amount of time you actually need the cash.
New 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 help make sure your enterprise is one of the successes that makes it past its fifth year.
This post was updated on 18th February 2021