How to Anticipate and Act on Them
Managing the cash flow of a small business can be tricky at the best of times. Limited resources mean that one wrong move can significantly affect the bottom line and the money in the bank. For example, one bad hire would not bring down a big business. However, hiring an unproductive or disruptive employee for a small business with only a handful of employees could be disastrous.
The effect of poor decisions or unexpected changes in fortunes may be more pronounced in a small business. But the underlying causes of cash flow problems are the same regardless of the size of the enterprise. If you know what those risks are, you are more likely to avoid them. Here are eight of those risks that could significantly impact the cash flow of a small business.
1. Declining Sales
Declining sales would be a concern for any business. However, monthly peaks, troughs, and seasonal fluctuations can mask a steady tail-off in sales volumes. Consequently, it is critical to analyze trends and make comparisons to the prior year.
If sales are declining, you will need to act to rectify the situation. For example, the product may require upgrading, prices might need adjusting, or there may be a need to increase or refocus marketing. In the meantime, it would be advisable to tighten spending to minimize the impact of the reduced sales income on cash flow.
2. Lack of Cost Control
Similarly, costs can creep up if not monitored and controlled. It’s advisable to compare actual expenditure against budgeted expenditure every month. You can simplify this review process with the use of percentage budget variances. Then you can focus your attention on the high-percentage negative variances. Trend analysis will also be helpful here, especially during a period of high inflation, to identify increasing costs.
3. Low Margins
Sales might be on target, but lower than anticipated gross margins will reduce profits and available cash. Hence the need to monitor gross margins. The probable causes of declining gross margins include increased direct costs, lower than the anticipated sales price, and production inefficiencies. The problem could lie with one or more products. Consequently, it’s advisable to monitor total, product category, and individual product gross margins.
4. Poor AR Management
Poor AR (accounts receivable) is a common cause of cash-flow problems. Once again, sales might be on target, costs under control, and gross margins as expected. Still, if you offer customers credit and don’t keep on top of collections, you will soon have a cash flow crisis. The simplest way to monitor accounts receivable is to review an aged accounts receivable report. Any balances in aging columns significantly over the standard credit terms are the ones to chase immediately. Tracking the average days to pay (Accounts receivable / Revenue X 365) will also indicate the trend in collection efficiency.
5. Inappropriate Borrowing
Obtaining credit is not as easy as it once was. Indeed, banks and other lending institutions now have strict requirements for business lending. Nevertheless, it is still possible to borrow money when not strictly necessary or the answer to the immediate issue. Sometimes, taking out a loan only papers over an underlying problem. For example, a company might be able to obtain a business loan to compensate for reducing sales, but that would only be a short-term solution. In the longer term, the loan would need repaying, and the issue with sales would still require attention. Therefore, it is advisable to be cautious about borrowing and look first at other solutions to solve a cash flow issue.
Stock sitting in a warehouse is an asset in accounting terms. It doesn’t hit the profit and loss account until you sell the goods. But if you are holding excessive stock, it will have a cash flow impact. Another crucial KPI (key performance indicator) to monitor is inventory turnover (Average inventory / Cost of goods sold X 365). This KPI indicates the number of days stock sits on the shelves. If inventory days are high or increasing, cash in the bank will reduce. Furthermore, it will not be easy to dispose of overstocked items fast. Consequently, overstocking poses a significant risk to the cash flow of any business selling physical products.
7. Expanding Too Fast
Expansion is good news, but it can stretch the cash flow. For example, a significant increase in sales also means increased costs. The raw materials and labor costs required to meet the increased demand will need purchasing before the cash from the sales materializes. Likewise, opening a new outlet will be risky because it will take time for sales from that new location to be sufficient to cover the increased expenditure.
8. Lack of Adequate Reporting and Forecasting
Except for disasters such as fire, flood, theft, or economic and political upheaval, threats to a business’s cash flow are usually predictable. However, the company must have adequate reporting and forecasting. Keeping the accounts up to date will enable you to spot trends as soon as they emerge. A long and short-term cash-flow forecast will allow you to see and prepare for future cash flow shortages. Doing the bookkeeping, budgeting, and forecasting may not be your favorite job. Nevertheless, that type of recordkeeping will help you steer your small business away from the typical causes of cash flow problems.
The Bottom Line
The overriding message to take away from this blog article is the need to maintain and review proper and timely accounting records. And that includes management accounts, budget variances, KPIs, a cash flow forecast, and accounts receivable. If you keep these financial records up to date, you will be able to see problems coming and act before cash flow issues become severe.
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