Why Profitable Businesses Still Run Out of Money

So what happens to profitable businesses? They fail to make payroll. This often surprises business owners, as they believed they were doing okay with their business. In reality, many profitable businesses have little idea of when money will be coming in. They do know that it won’t be on time.

A cash flow crisis occurs when the money that was owed to a business suddenly ceases to arrive. This leaves the business in a financial crisis that is devastating to owners and employees.

Research was conducted by U.S. Bank that reviewed closed businesses. It was found that poor cash flow management contributed to the failure of roughly 82% of small businesses that were shut down. It turns out that by understanding the financials of a business, owners can prevent their business from going under due to lack of funds.

Inside the article

What a Cash Flow Crisis Actually Looks Like

These are two completely different metrics. On paper, businesses show their profits, but they can run out of money. For instance, although a business earned $50,000 in a given month, the money may not have arrived yet. Therefore, it is possible for businesses to have enough profit on paper but to run out of cash.

While your business may be bringing in $50,000 or more in a given month, this does not necessarily mean that your business has $50,000 in the bank. Typically, there is a delay between when money is invoiced and when it is actually received by your business.

While your business is waiting for payments to arrive, the money is required to pay for a variety of expenses. This is known as a cash flow crisis and can cause financial problems for your business in a short amount of time.

The owner of a seasonal retail or landscaping business can invoice 70% of his or her annual revenue in a single three-month period. Then the money can stop for a long time. That’s a problem because the owner of such a business has to make payments on the equipment he or she uses and on the business’s liability insurance every single month, year after year.

The money has to keep coming in, even during the business’s slowest season, to keep the business alive. This is exactly the kind of pressure covered in Why Financial Timing Changes Everything for Growing Businesses, where timing, not just revenue, decides whether growth is sustainable.

Five Signs the Gap Is Widening

Cash flow problems can be growing for months before the crisis finally hits. In fact, according to the Federal Reserve’s Small Business Credit Survey, 44% of small businesses have at some point experienced a cash flow shortage severe enough to cause them to miss payments of their own expenses. Typically, these businesses are running on a thin margin between having enough cash to cover their expenses and not having enough. The difference is typically a matter of timing rather than amount.

Here are a few general warning signs that cash flow problems are occurring:

Using your credit cards or lines of credit to cover your payroll instead of using them for planned investments to grow your business.
Vendor payments are delayed on a regular basis.
Lack of a clear forward view (ie., what is owed and what is coming in over the next 30 to 60 days).
The business owner does not know how much cash is left in the bank each month.
Checking multiple bank accounts or spreadsheets manually just to estimate a current balance.

Note: The above points can exist alone but are usually a sign of a greater issue when they exist in multiples and on a regular basis. It typically signifies that a company is financially managing by cash flow as opposed to true financial management.

Why Spreadsheets Keep Failing Owners Who Are Trying Hard

The biggest problem with owners trying to manage their cash flow with spreadsheets is that there is a time lag between when the owner updates the numbers on the spreadsheet and when the actual cash flow is affected. By the time the owner updates the numbers on the spreadsheet, several things may have happened that affect cash flow, and the owner is unaware of them.

As mentioned above, in most cases there is a delay between when numbers are updated in a spreadsheet and when problems arise. The majority of the time, the business owner will be reviewing the most up-to-date numbers and have no idea that 3 large charges have cleared.

There is no alert system within spreadsheets. All spreadsheets can do is show a problem once it has arisen.

However, a huge amount of time and effort can also be spent reconciling and preparing the spreadsheets. Therefore, for many entrepreneurs, their financial management can actually end up taking up a huge amount of their time.

It was reported by the JPMorgan Chase Institute that on average, small businesses hold enough cash to last them for around 27 days in the event of a crisis, and that delay in realizing that there is a problem with cash flow can be the difference between them being able to cover any shortfalls that may arise and not being able to cover them, therefore resulting in them being late with payments.

How Real-Time Financial Software Closes the Gap

Many modern accounting platforms are able to sync with your business’s bank accounts, allowing you to view a real-time snapshot of your cash position. https://www.waveapps.com/ is an example of accounting software that has been able to achieve this.

Building on top of the accounting platforms’ real-time data syncs, a variety of new tools are being developed specifically to aid cash flow management. These tools typically plug directly into a company’s existing accounting software (such as Wave) to read in the raw transaction data that has already been entered into the accounting system by the business.

From here, the cash flow management tool builds a forward-looking cash flow projection based on a range of different criteria (such as the dates of upcoming invoicing, fixed and variable recurring expenses, and payment history for past-due amounts).

The 5 features to look for in a Cash Flow Tool to manage your Cash Flow Crisis.

Current Balance shown on Dashboard.
Cash flow forecasting, forecasting the cash position for a time period such as 30 days, 60 days, 90 days, etc. Based on the firm’s known cash flow obligations (eg invoices that have not yet been paid).
Automated invoicing and reminders. In order to receive payment as soon as possible, it is best to send out invoices and reminders to late-paying clients as soon as possible.
Custom low-balance alerts, alerting you to potential low-balance situations weeks before they actually occur.

However, I must note that none of the above will ever completely eliminate all cash flow risk; but what it will do for a business owner is change what was previously thought to have been a financial crisis into something that the owner now has time to go and fix before it becomes a problem.

What This Looks Like in Practice

A marketing agency with five employees and several retainer-based clients has revenue that looks to be in good shape. However, two of the clients are paying 45 days late instead of the agreed-upon 30 days. Without using forecasting software, the business owner would not even be aware of this pattern until a month later, when the owner has to pay for things like payroll and a software renewal.

With cash flow forecasting enabled on the live bank data, and connected to all outstanding invoicing (with their respective payment terms), the owner can see (in 3 weeks’ time) that there will be a cash shortfall just in time to act (e.g. follow up on those late paying invoices, delay a discretionary spend, use a credit facility to fund the shortfall, etc).

This is to note that the agency’s cash flow crisis is not caused by the late paying of its two largest clients. Rather, the opposite, i.e., that the owner is able to manage the late payment of these two large clients in time, because he has been alerted to the impending cash flow shortfall in 3 weeks’ time, thereby able to take the necessary action to prevent the cash flow crisis from actually happening in the first place.

What to Look for When Choosing a Tool

We compare key cash flow forecasting features for accounting platforms used by small business owners. We review features of several accounting platforms during a free trial to see whether each platform will work for a small business owner.

Syncing with bank accounts directly (as opposed to having to import CSV files) is a dealbreaker; forecasting functionality is more important than reporting functionality; ability to send out automated invoices and track payments in real-time can help to reduce the receivables gap that causes the majority of timing problems; and the software needs to be easy to use for someone without an accounting background (i.e. most small business owners).

While the costs of different cash flow software can differ quite a bit (ranging from around $15 a month to over $150 a month for bigger businesses), they can often be written off against the costs of having a single late payment, or the interest on an emergency loan.

The Real Takeaway

Cash flow problems typically arise as a result of not knowing what is going to happen and then things deteriorating quickly. Businesses that manage to get through tough times are likely to have a number of cash in the bank, but they will also have managed to see that things were about to go wrong a number of weeks before they actually did.

It is not software that is being sold here, but rather visibility. For the business running on a 27-day cash buffer, the lead time provided by these financial tools is in fact the entire margin between a rough month and being closed for good.