Most Common Financial Mistakes That Lead to Cash Crunch
“Turnover is vanity, profit is sanity, but cash is king” is a financial adage sometimes ignored and too often forgotten. Many a business has failed not because of lack of opportunities or a weak market or a bad economy, but simply because its managers failed to manage cash properly.
When “analyzing” financial statements, the usual trend for untrained readers is to go directly to the income statement bottom figure, gloss over the equity section of the balance sheet, and skip the cash flow statement (CFS) altogether. Many may not realize this, but skipping the CFS is very dangerous, since the CFS is one report that can show financial management issues that may prove to be detrimental to the company later on.
Profit Is Sanity, but Cash Is Reality
I find it apt to insert a short review of one of the most basic accounting principles employed in most businesses today: the accrual basis. If you recall, the accrual basis of accounting is defined as “a system of accounting under which revenue is recognized (recorded) when earned, and expenses are recognized when incurred. Totals of revenues and expenses are shown in the financial statements (prepared at the end of an accounting period), whether or not cash was received or paid out in that period.”
In other words, it does not always follow that when a company is “profitable,” it can readily pay its debts or have the funds needed to continue operations. This is so because the recognition of revenue and, consequently, profit does not mean the company received actual cash representing said profit. Thus, it may well happen that a profitable bottom figure may allow stakeholders to keep their “sanity,” but all that is just paper until actual cash is received to make the profit “real” and tangible.
Of Crunching Cash and Numbers A cash crunch can simply be defined as “a cash crisis.” The definition is pretty self-explanatory. However, the application in a real world scenario may not be as so.
Consider a year where your company invested all its capital in P10M worth of inventory and managed to sell all of them outright to Mr. A for P15M on December 30. To keep things simple, let’s assume no other expenses were incurred; thus, we can say that the company’s income statement will show a profit of P5M for that year. Now since the credit term for your customers is sixty days, Mr. A has until the end of February the following year to make the payment. Now the question is, what happens until then?
What if the company has rent, employees, utilities, and other fixed overhead expenses to pay? Do shareholders need to inject more capital or take out a loan this early in the game? Or does this mean the company has to shut down for sixty days until it collects from Mr. A and again has cash to operate?
The scenario presented above illustrates a simple example of poor cash management resulting to a cash crunch. The manager failed to take into account that it is unwise to tie up all the company’s cash in nonliquid assets, without taking into consideration payables and other fixed or unforeseen costs becoming due and payable before the time it expects to convert said assets to the cash needed to cover said liabilities. This results in high opportunity costs, high interest expenses, damaged relationships with suppliers, customers, and employees, etc., which may later on collectively cause the business to fold over.
Common Cash Crunch Causes
Summarized here are a few of the most common financial mistakes new entrepreneurs and managers often commit that might lead to a cash crunch. For those not so “new” in the business world anymore, you may still get some ideas or maybe a reminder or two.
Inventories—tying up too much, seasons change
One common mistake among startup entrepreneurs is getting too excited and directly investing a huge chunk of the company’s capital in inventory. We must remember that just because we have the stocks, it doesn’t mean that customers will now flood our store to buy them off our hands. Sometimes we forget the needs or supply for our products are seasonal—scuba gear manufacturers can’t expect high sales in winter, can they?
Keep in mind that new entrepreneurs still need to promote and let the world know the company exists (or wait for the products’ season to arrive), while, at the same time, make sure that it indeed does continue to exist by paying utility costs, rent, employee salaries, etc. These are what you call fixed overhead. Furthermore, storage costs also have to be incurred for each unit of inventory (an example of variable overhead). All these the company must continue to pay for regardless of whether or not a sale is made and cash is collected to use as payment.
The cash conversion cycle (CCC): the shorter the better
The cash conversion cycle is the total time it takes for a company to convert cash invested in the business, go through the business process, and get converted back to cash. It is basically the sum of the following:
Inventory conversion cycle = the number of days it takes for inventory on hand to get sold + Average collection period = the number of days it takes to collect cash for the receivables on hand + Payables deferral = the number of days suppliers allow the company to hold off payment/credit terms
The formulae needed to compute for the above components are more aptly discussed in a finance piece. However, for this article’s purpose, I would want the reader to take at least three things from the discussion of the CCC.
1. Although liberal credit policies attract a lot of customers, you must remember that a sale is not “complete” unless it has been collected. Thus, in formulating credit policies, take into account not only the credit worthiness and the expected sales, but also the fact that you need the cash as soon as possible to continue operating. One related reason for this need is no. 2 below.
2. Payables deferral, or days payables outstanding, is your credit term with your suppliers. Bluntly translated, it’s the time you are given to come up with the cash needed to pay. Needless to say, this “grace” period must be taken into account in coming up with credit policies and collection strategies for your own customers. Try to equal, if not, lessen, your collection period compared to your payment periods to eliminate the need to find other sources of financing when payables already come due but cash is still tied up as receivables.
3.The previous number discusses about shortening the collection period for receivables, and the most common strategy to support this is giving early-payment discounts. In making policies for this strategy, however, make sure to balance the rate of the discount with the benefits you expect to derive from such early payment. Take into consideration collection risk and interest rates in doing so.
Excess Income Accumulation—too much of a good thing
At a certain point in time, a company may have accumulated profits through the years. In line with this, many companies forget to consider that Philippine tax laws generally prohibit the accumulation of earnings beyond the reasonable needs of the business, or else they pay a 10 percent tax on improperly accumulated earnings. (Sec. 29, National Internal Revenue Code)
This means that it has to either allocate a portion of its retained income for a definite expansion program or pay out the said or the remaining amount as dividends, leaving only a balance up to 100 percent of paid-up capital as of balance sheet date.
Keep in mind that as mentioned before, profits are not synonymous with readily available cash, and if cash is not managed properly, the company may have to sell some of its assets just to generate the cash needed for compliance.
Too-rapid growth
Expansion is always a welcome option for most, if not, all, companies. However, what some managers forget is the fact that the rate of growth should also be kept in check to make sure this can be supported by current operations.
A factory expansion for additional production lines, for example, will mean cash taken out from the company’s working capital to be tied up in long-term, nonliquid assets. Thus, if current cash flows cannot support the expansion, either defer expansion or consider obtaining additional financing (debt or equity) and find terms that give optimal cash-flow results, taking into consideration both payment terms and project payback projection rates.
Unexpected events
When we were young, the ants taught us to always save for rainy days. Just like in any aspect in life, uncertainties exist, and one must never make the mistake of neglecting to provide for contingencies. Have some buffer funds in store, take out insurance, spread some investments in another basket. These are some things many businessmen forget or neglect to do, especially when business is doing well.
While it is true that planning and strategizing prevent not only cash crunches but also other forms of crises, no one is ever certain if and when disaster or other unexpected events may occur. Thus, having plans B, C, D, and E ready up your sleeve will most certainly never hurt.
Originally published at foundersguide.com
