There may be other reasons why companies go out of business, but it seems to me that they ultimately all come back to one: money.
Cash is the lifeblood of every business entity, which is why cash management needs to be a top priority for every entrepreneur.
Cash generation is often not related to the overall health of a business. Even sound, growing, dynamic businesses can fail because they consume more cash than they produce. Temporary cash shortfalls are common in the business world and can be survived comfortably if they are planned for and managed well. Consider three common cash management mistakes entrepreneurs make:
• Failure to carefully manage cash consumers: There are three major cash consumers in most businesses receivables, inventory and capital investments. The more quickly a business grows, the more cash will be required to carry the increased receivables as well as the inventory produced by the growing business. Additionally, capital costs (investment in computers, vehicles, furniture and the like) typically grow in thriving businesses.
• Growing too fast: Most businesspeople are highly focused on growth. Healthy businesses generally grow over time. But if growth comes too quickly, it can easily overrun the company's ability to generate the cash necessary to pay its bills. Although it sounds counter-intuitive, good businesses can die because they grow more rapidly than their cash can sustain.
• Not projecting cash flows and planning ahead: This is probably the biggest and most common mistake made by new entrepreneurs. Although there are many ways to deal with temporary cash shortfalls in a business, the most important need is to plan ahead and prepare for them well before they happen.
Bankers and other financing sources are much more willing to help a business with cash problems if management saw them coming and already has a plan in place to solve them in a timely way. If, as is often the case, management waits until the crisis is upon them, they look unprepared and fail to generate the confidence required for a lender to provide the additional capital required to survive the cash crunch.
Most businesses are reasonably predictable, at least within certain parameters. A clear 12- to 24-month monthly projection of financial performance will generally predict cash shortfall periods. This doesn't require sophisticated software. A simple extrapolation of current financial statements in any spreadsheet software program will allow you to project with reasonable accuracy the elements of your business by line item. The longer you run the business, the more predictable the patterns will become.
Every month when new financials become available, those should be entered into the pro forma with careful attention to variances from the earlier projection. The projection will become a valuable road map spelling out the cash requirements of the business in coming months.
Too often it comes as a revelation to entrepreneurs that there can be a significant difference between financial statement profits and free cash flow in a business. I have a friend who owned a parking business. He had no receivables, and his inventory was simply the parking stalls on his property. He had minimal capital costs.
He told me that if his financial statement showed a profit of x, he could declare a dividend of x-10% because the cash flow closely mimicked the stated profits.
On the other hand, I owned a technology company that carried receivables and had a considerable capital cost as we continually reinvested in the new technology necessary to keep our products and services on the cutting edge. If our profit was x, we struggled to declare dividends equal to x-90%.Although profits are the Holy Grail for businesspeople, current and future cash flows are actually a more accurate indicator of the health of a business. If inadequate cash flow is far and away the No. 1 reason entrepreneurs go out of business, good cash management will assure that you don't experience it.
Andy Barfuss is affiliated with the BYU Center for Entrepreneurship. He can be reached via e-mail at [email protected]