The Most Common Reasons Behind Business Cash Flow Issues
Is your business having issues meeting expense and debt obligations due to not having enough available cash? Or perhaps you’re just barely scraping by each month and want to know ways to improve the situation. In this article, we’re going to go over the 10 most common reasons businesses experience cash flow problems and how to deal with them.
Weak Sales
Probably the most obvious possibility is weak sales. Have you seen sales decrease recently? Or are sales stagnating while costs are increasing? This could be due to the business being seasonal, a downturn in the economy, supply chain disruptions, inefficient operations, poor customer satisfaction, loss of a large account, and many more.
The first thing you need to do is understand why sales are weak. Is it something you or your staff are doing wrong or is it something out of your control? The next step is to decide what can be done about it. Can it be mitigated by introducing a new revenue stream, cutting costs, improving customer service, using different sales or marketing strategies, and so on? You may need to try several different tactics until you find a formula that works.
Underpriced Services or Products
Related to weak sales is underpriced services or products. Maybe your sales totals aren’t enough simply because you’re not charging enough. If your number of sales is high but your total revenue is lackluster, it’s a clear indication that you are undercharging.
Businesses often come up with a price leader strategy to differentiate themselves from competitors. It can work for companies large enough or with deep enough pockets to take advantage of bulk purchasing discounts, economies of scale, supply chain mastery, or efficiency methods like six sigma and kaizen. For small businesses, however, being a price leader can be a recipe for insolvency.
Your first priority as a business is to price services or products at a point in which you can at least cover your cost and debt obligations each month. But that’s only if you want to break even all the time. Ideally, you want to achieve a profit each period. So, you need prices that can yield more cash inflows than cash outflows.
Cost plus pricing is one of the most common price setting methods and one of the easiest to calculate. Start with knowing your total average cash expenditures and add a reasonable profit margin onto that in order to come up with what you need to be charging. Of course, that begs the question, will the market bear it? That’s where researching competitor pricing comes in. You don’t have to be right on par with your competitors on price, but you should be in the general ballbark.
Slow Accounts Receivable Collection
Do you have someone billing customers promptly after service is rendered or products are ordered? Who’s staying on top of collections? How long does it take to collect receivables? These are some of the questions you need to be asking yourself.
Know what your accounts receivable turnover ratio is and days to collect accounts receivable. If you’re not comfortable working with financial ratios, seek out a good accountant to help you. 8 or more turnovers a year is usually considered good. Ideally, you should be able to collect all accounts receivables within your payment policy timeframe. So, if you give customers 30 days to pay, it shouldn’t take much more than 30 days on average to collect. If average days to collect is significantly longer than 30 days, such as 50 to 60 days, it indicates a problem.
Make sure you have someone dedicated to sending out invoices as soon as possible after services are rendered or products are sold. Someone should also be running an accounts receivable aging report each week and contacting delinquent accounts. Sending a payment reminder before the due date arrives can help with avoiding overdue invoices in the first place. See if some of your customers will let you do an auto draft so that you don’t have to wait on a check. And consider shortening the due date on invoices to expedite payments.
Excessive Bad Debt
Do you find that customers often will not pay their invoices? Do you have a large job that you had to write off because of a deadbeat client? When customers stiff you on the bill, it gets written off as bad debt. Unfortunately, bad debt is part of doing business. Most companies experience the sting of it at some point in their existence. When you provide services or products on account, it’s especially apt to happen.
There are a few things you can do to protect against it, however. Make sure you have a credit application process for customers. Don’t just approve anyone; make them pass certain checks first. Consider setting up auto drafts instead of waiting on checks. Upfront payments before work commences or milestone billings can help mitigate losses. And aggressively pursue overdue accounts. If the amount is large enough, it may be worth your money to pay a collection agency to try to recover the debt for you.
Overstocked on Inventory
Does it take a long time to sell through inventory? Is inventory going bad or becoming obsolete too often? Businesses that carry inventory inherently use more cash than others because you have to buy a stock of products before you can even begin making money, and then you have to take a sizable portion of what you make to replenish stock levels so that you continue to have items to sell. As a result of the amount of money tied up in inventory, companies are often short on available cash for other purposes.
That’s why it’s so important for companies with inventory to watch their ratios and not tie up any more cash in inventory than necessary. Look at your inventory turnover ratio and avg days to sell inventory. A good turnover ratio for most industries is 6 or more. That means that you sell and restock your inventory every 1 to 2 months. If it’s taking much longer than that, you’ve probably got too much cash tied up in inventory and need to lower your stock levels to free up cash that can be used elsewhere.
Too Much Debt
Loans are a necessary evil for a lot of businesses. They often need them to start up operations, expand operations, for large asset purchases, and for temporary operating cash shortfalls. But there is such a thing as being overleveraged with debt.
Does it seem like a significant chunk of your cash is going to pay for loans each month? Look at your cash to debt ratio and current ratio. The current ratio should be at least 1 but 1.5 or better is ideal. In general, a cash to debt ratio of 50% or better is considered good, but this can vary depending on the industry. Consult with an accountant that’s experienced in your industry to find out if yours is normal.
If too much debt is causing cash flow issues for your business, set a plan to get it paid down to a more healthy level. Better yet, pay off debt early and you can avoid a lot of interest. Keeping a monthly budget and doing cash flow projections are important tasks in making sure your business doesn’t take on more debt in the future than it can comfortably pay.
Unexpected Expenses
Unexpected expenses can arise due to various occurrences, including significant repairs, asset replacement, theft, lawsuits, and natural disasters. If you don’t have an insurance policy that covers it, you will have to pay out of pocket and watch your cash level take a dive, or else take on a new loan that can cause further problems for your business (see above).
There are some things you can do to guard against these kinds of expenses, such as regular maintenance on your assets, a good security system, and having the right insurance policies in place. But at the end of the day, certain events just can’t be helped.
That is where having a rainy day or emergency fund for your business comes in handy. If you haven’t already, begin saving a percentage of your spare cash each month in a separate business account so that you can be ready for unexpected costs.
High COGS or Overhead Costs
If the net profit on your income statement seems to always be very low or you have net losses, and you haven’t seen any major disruptions in sales, then you may want to look at your expenses.
If you sell products or have job costs, take a close look at what you are paying for your inventory or materials. Are there cheaper suppliers available? Are there alternative goods that you could buy? Are there discounts available that you’re not taking advantage of?
Overhead costs like rent and utilities could be eating up your cash as well. Look at average rent prices for the kind of business space you need. Consider leasing somewhere else once your current lease is up if you are paying significantly more than average. Look at ways to save on energy usage, such as having a lights out policy for unused rooms or turning up the thermostat in the summer and turning it down in the winter.
Look at your other costs the same way and see if it’s possible to lower them. Are there a lot of avoidable costs on your income statement such as for entertainment, meals or unnecessary travel? Those are usually the easiest to cut out.
Overall, establishing a budget and managing it closely is the best way to control costs.
Excessive Owner Draws or Owner Salary
Just as people have problems with budgeting personal funds and can cause accounts to become overdrawn, the same often happens with business accounts.
Take a look at the owner’s draws or distributions on your balance sheet. Is it a large amount? Sometimes people don’t realize how much has been taken out over time. That’s why it helps to look on a regular basis.
The best way to guard against excessive draws is to include them in your cash budget and place a strict limit on them.
A distribution is only one way that an owner can hurt a business. Many are also on payroll. One of the hardest things to get an owner to think about is lowering their own salary. Many see it as their right to pay themselves the salary they think they deserve. But you also need to consider whether or not the business can bear it.
I’ve seen owners take six figure salaries in small businesses that bring in less than a million in revenue per year. Those companies tend to consistently experience net losses. All it would take for the business to experience net profit every period is for the owner to take a more moderate salary.
Does the salary seem excessive compared with the size and revenue of the business? If your payroll to revenue ratio is above 30% and your salary is high, you might want to consider taking a pay cut.
Unnecessary Loans
If you’re giving out a lot of loans to employees, associates, or friends and family from the business, it can cause a cash deficit in the short-term and possibly in the long-term if the loans aren’t paid back in a reasonable amount of time.
The best policy is not to give any personal loans from your business accounts. Employee pay advances are fairly common among employers and are fairly safe to make, as the employer simply withholds money from the employee’s next paycheck to get it back. But large advances should be avoided; limit an advance to what the employee can reasonably pay back in the next pay period or two.
If the employee is needing an advance regularly, it may indicate that the individual is trying to use the business to cover for his or her poor money management skills. To protect against that scenario, it’s best to place a limit on the number of pay advances per year for each worker.
Conclusion
These reasons for poor cash flow all underscore the importance of good accounting. You need someone assessing key ratios. You need someone staying on top of collections from customers. You need regular reporting on operations, including project and revenue stream profitability. You need someone benchmarking your financial results and pricing to other businesses in your industry to see how you compare. You need a monthly budget and forecast to help control expenses and plan into the future. And you need someone who can advise you on what the problems are and how to avoid them.
