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Cash Flow Difficulties: The Main Problem Or A Symptom Of A Deeper Problem?

From time to time, a business owner will contact me and ask for a free Business SOS because their business has cash flow difficulties.

The first issue we face is the problem of diagnosis. A business may be experiencing cash flow problems for a number of different reasons and curing the problem for the long term means getting to the root cause.

Cash flow difficulties normally mean that the business is struggling:

  • To pay suppliers when they chase for their money after selling on credit, or
  • When another supplier insists on payment on order or delivery and no money means no goods, or
  • When the business owner is struggling to find the money to meet the weekly or monthly payroll, or
  • When  the business can’t meet a periodic payment like the quarterly rent or VAT, or
  • When the business owner wants to take money out of the business for personal use and the money isn’t there.

The Causes Of Cash Flow Problems

  1. The business has been started with too little money introduced by the owners. In the accounting jargon, it is undercapitalised. Many businesses need to buy some equipment at the beginning and, unless they receive cash in advance of delivery of the goods or services, they also need to finance the working capital of the business.
    This working capital is stocks and work in progress, debtors including customer invoices where the items have been delivered but the customer hasn’t yet paid less creditors which is money owed by the business to others.
    If your business is undercapitalised, you may have had cash flow problems from the very beginning but it can also happen if your business suddenly starts to grow quickly. Generally working capital requirements increase in line with sales increases.
  2. The cash flow of the business is being mismanaged. Your working capital requirements depend on the decisions you make about buying stock in advance, about the payment terms you negotiate with customers and suppliers and how well you enforce terms with your customers through effective invoicing and credit control. Most businesses have a predictable cash flow cycle of good months followed by bad when, for example, property rent and VAT are paid. Cyclical businesses where sales level peak and trough predictably over the year have longer cash flow cycles as working capital requirements ebb and flow and long term contract style businesses are particularly unpredictable.
  3. The business is trading unprofitably. A profitable business will, over time put more money into the bank than it takes out. Cash flow issues should reduce as the business accumulates these reserves of past profit and the cash ripples through the working capital timings. In contrast, an unprofitable business has the opposite effect. A profit deficit accumulates which leads to less money in the bank.
  4. The business owner takes out more money than the profit can justify. Exactly how this works will depend on the legal form of the business – sole trader, partnership or limited company – because of the difference between “drawings from capital” and salary or dividends. A business making a trading profit of £3,000 per month is in trouble if the business owner keeps taking £6,000 out each month.

I’m classifying the first two issues as a “cash flow problem” but issues 3 and 4 are more of a profitability problem with the main symptom arising through the cash flow.

How To Solve A Cash Flow Problem

There are only three general ways to solve a cash flow problem:

  1. Collect money owed to you faster. This may involve negotiating a deposit from the customer which is paid when the order is placed, raising invoices for stage payments if the job is done over a period of weeks or months, by making sure your invoices are raised promptly and accurately, by reducing the credit terms offered to customers, perhaps by offering a quick payment discount or by chasing up overdue items effectively.
  2. Pay out money owed by you slower. There are two issues involved on the payments side – when you buy and when you pay. Can you operate with less stock which will mean that you delay orders for stock replenishment? Can you negotiate better terms from your suppliers or find alternative suppliers who will give you more credit? Are you being a “payment goody-goody”? It’s very nice to pay suppliers before or as soon as the money is due but they will normally allow some flexibility before it causes problems to the relationship. HM Revenue & Customs can be flexible through the Time To Pay scheme if you are genuinely finding it hard to pay VAT or PAYE/NIC. You can talk to them yourself and agree a payment schedule or many insolvency practitioners will do it on your behalf. This insolvency website is helpful on Time To Pay.
  3. Increase the profitability of your business. Your profit (the difference between your revenue and costs) will gradually create a fund that finances the business. In the short term this means increasing the profit on products and service jobs, rather than increasing sales volumes which is likely to increase the need for working capital and make the cash flow worse.

A short term fix is to get a loan from:

  • A bank,
  • Your own personal funds,
  • Your family or friends.

The easiest source is money from yourself, if you have any spare savings available to lend to your business. This may involve borrowing through your personal credit cards or other personal loans.

Getting a business loan or overdraft from a bank will require you going through a formal process which may involve producing updated accounts, a business plan with cash flow forecasts and giving the bank some kind of security for the loan, either against the business assets if suitable or against your personal assets through a specific pledge or a personal guarantee.

If you don’t have any spare money of your own and without the ability to give banks any security, the only short term option is to get a loan from your family or friends to tide you over. However it is critical that you are profitable because, if your business is losing money, you will just burn through their money and be back in the same position.

How To Solve The Cash Flow Symptoms Of A Profitability Problem

If your business is unprofitable, it means your costs exceed your revenue. Over the long term, this inevitably means that payments out will exceed cash receipts coming in.

The actions above to deal with a cash flow problem will provide some temporary relief but they are the equivalent of “papering over the cracks”. Unless you solve the profit problem, any actions will be futile over the longer term. You’ll just “dig a deeper hole” and lose more money for yourself, your lenders, your suppliers and potentially your customers when your business goes bust.

To be sure that a profit problem is not happening, you need to have your accountants prepare a Profit & Loss Account and Balance Sheet and then talk you through the implications.

While I am sure that you have tried to price products and service jobs profitably, some things can go wrong:

  1. The job takes more labour hours than expected.
  2. Your labour is more expensive than you thought, which might happen if you haven’t allowed for national insurance and holiday pay.
  3. Your materials are more expensive than expected, either because price is higher or you have had to use a larger quantity.
  4. You incur quality problems that lead to rework, meaning more labour and materials.
  5. You incur quality problems that lead to penalty payments where you don’t receive the full revenue you expected.

Then there is the issues of:

  1. Is your labour working on jobs all the time or are there quiet periods where you have to pay them when waiting for the next job to become available to you.
  2. Whether your profit from the products or service  jobs, after deducting all the direct costs, is insufficient to cover all your overhead costs.

Where practical, I encourage people to operate a simple job costing system where labour time and actual material costs are booked against specific jobs. This way you can compare what has happened with what you thought was going to happen.

The general solutions for improving profitability are available through break even analysis:

1) Increase sales prices of products or jobs.
2) Decrease the direct cost of products jobs.
3) Decrease the general overheads of the business. This may involve you making the hard decision of cutting back on your own salary or taking other family members off the payroll if the cost is greater than the value they provide.
4) Increase the number of profitable products or jobs sold.

A Business Turnaround Focuses On The Core

Standard economic and accounting theory says that you solve a profitability problem mainly by growing the business. On the Break Even charts, this involves moving “North East” (towards the top right hand corner) to higher sales prices and/or higher sales volumes.

Business turnarounds in practice often don’t work out like this. Instead the business cuts back its operations and its scope to concentrate on a profitable core of activities.

This happens because a business has tried to grow ineffectively. It has added new activities but those areas have increased costs more than revenue.

To know if you’re in this situation, you need more sophisticated accounting reports that analyse your different product-market performances together with judgement on how you would trim your general overheads if you pulled out of various markets.

Getting Financial Control Of Your Business

You need to understand what is happening and know whether you have a short term cash flow problem or a longer term profitability problem.

You would do that by asking your accountants to prepare an up-to-date Profit & Loss Account and balance sheet for your business and then ask them to talk you through the implications. This requires that all your transactions are entered into your accounting software quickly.

If you can show you’re profitable, you will feel more comfortable about borrowing from family and friends or you may find that, armed with the right financial information, your bank is prepared to increase your overdraft.

If you’re not profitable, your situation is much more serious and it will require more fundamental changes in the way you’re working.

You Must Understand Whether Cash Flow Is The Problem Or The Symptom Of A Deeper Profitability Problem

Borrowing money may look like the easy thing to do to cure the immediate pressures to pay employees and suppliers. If your business is losing money and you don’t make the changes needed, you’ll have wasted the money from any loan.

If it comes from a bank, this may have serious consequences for you through any personal guarantees. If it comes from your family or friends, you may have ruined your relationship with them.

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