Most small businesses encounter a cash flow problem at one time or another. Fortunately, most cash flow problems can be prevented with a bit of preparation and the right strategy.
This article lists the 12 most common causes of cash flow problems, along with ways to solve them.
1. Not having a cash reserve
Most small businesses have an inadequate cash reserve. Or worse, they have no cash reserve at all. This situation leaves businesses unprepared to handle unexpected circumstances and emergencies.
An inadequate cash reserve is probably the most common cause of cash flow problems. It is also the simplest to solve. A proper cash reserve allows you to weather short-term emergencies. It also allows you to focus on running your business during difficult times, without affecting operations.
The solution is simple but requires discipline. Start building a cash reserve for your business. Having a budget of current and forecasted expenses helps in this process. You can use the budget to determine the size of the reserve.
Depending on your circumstances, build your cash reserve to cover a few months of business expenses. Three months is a common number used by experts.
To build the reserve, divert a small portion of your revenues to a separate savings account. Grow the value of the account until you reach a level that provides you with comfort. Don’t use the account for anything other than an emergency.
2. Slow-paying invoices
Slow-paying invoices are a common cause for cash flow problems. As a small business owner, you have to offer 30-day to 60-day payment terms to clients. However, small companies can’t always afford to wait this long for payment. They need money sooner. Eventually, slow payments create a financial problem that can seriously affect your business – even if it’s growing quickly.
There are two ways to solve this problem. One solution is to provide clients with an incentive to pay faster. Offering a 2% discount in exchange for a payment in 10 days can motivate clients to pay quickly. However, this incentive needs to be negotiated directly with each client.
An alternative is to use invoice factoring to finance slow-paying invoices. This method improves cash flow immediately and enables you to offer payment terms with confidence. To learn more about factoring, read this article.
3. Expensive debt
Excessively high debt payments often cause cash flow problems. Consequently, the company can’t afford its existing financing. This problem is common for companies that have cash advances (also known as Merchant Cash Advances) or other high-priced loans.
If the cost of debt is too high and takes most of your revenues, consider refinancing the loan. This option enables you to replace a loan with high payments with a new loan that has lower payments. Payments can be lowered by either extending the length of the payment terms, lowering the interest rate, or both.
If you have multiple loans, you can achieve the same objective using debt consolidation. Consolidation combines multiple loans and replaces them with a new, single loan with more affordable payments.
4. High overhead expenses
Overhead expenses are the costs of running a business that are not tied directly to selling a specific product or service. Examples of overhead include rent, telephone, utilities, etc. Sometimes overhead expenses get out of hand relative to the revenue the business produces. High overhead expenses can hurt your business’s cash flow.
High overhead expenses are particularly challenging because they are persistent. These expenses affect your cash flow every day until the problem is corrected.
The solution to this problem is simple, but it is not easy. Audit your expenses and cut back where you can. Be careful not to cut too much, as that approach could also hurt the company.
If you cannot cut back, consider cheaper options. In fact, every business should audit expenses regularly to ensure that overhead expenses stay in line.
5. Excess inventory
This problem can affect companies that manufacture goods or re-sellers that keep a warehouse stocked with products. If too much product is made or purchased, it ends up sitting on shelves and tying up cash flow.
Fine-tune your inventory so that you stock items for the shortest possible time before being sold or used in the manufacturing process. The amount of product you keep in stock depends on your volume, sales forecasts, available cash, and supplier capabilities. Monitor inventory levels carefully. Having key products out of stock is a sure way to lose clients.
Companies that re-sell products can also use purchase order financing or supplier financing to finance large sales that exceed their cash flow capabilities. When used correctly, either solution can improve your cash flow and allow you to handle the supplier expenses associated with large orders. For more information, read this article.
6. Bad (or no) bookkeeping
Most business owners dread handling the bookkeeping of their businesses. For many, it’s a boring activity that takes a lot of time and is not “productive.” This type of thinking is a mistake.
Having bad bookkeeping (or none at all) can seriously impact your business. You won’t be able to track payments, deposits, or any financial activities accurately. It will also prevent you from getting financing or even paying taxes correctly.
Work with someone to set up your bookkeeping and bring it up to date. Once it is up to date, ensure that it stays current. Depending on the size of your business, consider outsourcing this task or employing a bookkeeper.
7. Ignoring your financial statements
Keeping good accounting records does not help your business unless you review your financial statements regularly. Unfortunately, many business owners ignore this task and review financial statements only when they have financial problems. Reviewing your financial statements allows you to identify potential problems before they happen.
Review your financial statements as often as necessary. At a minimum, look at them once a week. Keep in mind that this is helpful only if your accounting system is up to date. We recommend you review the following statements:
- Payables aging
- Receivables aging
- Cash flow statement
- Profit and loss
- Balance sheet
- Bank statements
If you need help understanding your financial statements, ask your accountant for help.
8. Incorrect sales forecasting
In anticipation of greater sales, owners often ramp up their business investments. They want to capitalize on the expected demand. If the expected demand never materializes, the business faces a financial loss. This scenario often leads to cash flow problems.
Every business misses sales forecasts at one time or another. It comes with owning and trying to grow a company. However, there are ways to decrease the cash flow problems that often follow. They are:
- Have an emergency cash reserve (See #1)
- Handle growth through outsourcing (or temp employees) at first
- Deploy conservative (rather than aggressive) growth plans
- At first, rent extra assets instead of buying them
9. Employee theft
Employee theft is a serious problem that affects cash flow. Theft can take many shapes and sizes and can be very difficult to catch. Examples include employees who:
- Redirect payments and cover up related financial entries
- Alter invoices and pocket the difference
- Steal products through a number of methods
- Steal money through payroll (e.g., unearned time or business expenses)
This problem is very complex. It can be difficult to catch and fix. If you suspect you have employee theft, consider working with a professional.
Steps you can take to minimize employee theft include:
- Solid screening procedures for new employees
- Checks and balances for employees who work in sensitive positions. Having two employees handle critical tasks (“the buddy system”) works well to prevent dishonesty
- Use video cameras in key areas
- Get a bond on certainly employees
- Audit everything regularly
10. Seasonal demands
Seasonal businesses require careful cash flow management and planning. Otherwise you may end up with cash flow problems during the low season. This problem is common for certain types of businesses.
There are a few things you can do to manage this situation successfully. Many of them are covered in other sections of this article as well. First and foremost, establish a reserve fund (see #1). This fund helps cover expenses during the low season. Additionally, establish a process to start forecasting sales (see #7) and expenses accurately. This step enables you to build your cash reserve correctly and plan accordingly. Lastly, your company can also use a line of credit to help with expenses during the low season. However, we consider using a line of credit as a last resort.
11. Too much bad debt
Bad debt occurs when you sell product, or provide a service, to a client who does not pay. Bad debt presents an obvious harm to your cash flow and your profitability.
The solution to this problem is to review the commercial credit of your clients before you extend payment terms. Provide terms only to clients who have good credit and a solid payment record. Others should prepay until they have built a track record with your company. This strategy may cost you some sales. However, it only costs you clients who were deemed credit risks to begin with.
12. Insufficient gross margins
Small businesses sometimes sell their products and services for such low prices that they have low, or negative, gross margins. This scenario often happens in highly competitive environments with constant pricing pressure. It usually affects small business owners who do not have a clear understanding of their costs.
To solve this problem, audit all your products and services to determine the all-inclusive cost of delivering your products and services. This step is difficult but necessary. Once you have determined the all-inclusive cost, do the following:
- If you can, raise the prices of products/services that have weak margins
- If you can’t raise prices, consider dropping products/services that have weak margins
- Ensure that all proposals price your products according to their cost
One thing to keep in mind
Cash flow problems can be serious and threaten your ability to stay in business. If you don’t have direct financial experience, consider working with a CPA or financial expert to help you determine which problems you have – and how to solve them.
Get more information
We are a leading factoring and purchase order financing company and can help you with your cash flow problems. For more information, get an online quote or call us toll-free at (877) 300 3258.