This was one of the many rude shocks I learned the hard way: a profitable business can run out of cash and go bankrupt! Furthermore, fast growing businesses, even highly profitable ones, can continually run out of money and continually skirt with being forced into bankruptcy!
Why does this happen? It generally occurs because your business is undercapitalized. In other words, your business doesn’t have enough money to support the level of sales it is generating. Furthermore, the more your business grows, unless the net worth of the business grows at least at the same pace as sales, the situation will only get worse the more the business grows.
Why does your business need money to support growing sales? If you are selling a product, you need money to buy or build inventory. If you are selling on credit, then you need money to carry the receivables until you get paid. And in both product and service businesses, you often have a negative timing issue: you must pay for costs in building your products or providing your services before the customer pays you.
For example, in my book publishing business, we usually had to pay our printing bills in 30 days. But the retailers and wholesalers who bought our books usually paid us in 60-90 days. So, we had a timing issue. Furthermore, it was not economically profitable to print a small quantity of books, so we typically printed enough books to last 12-18 months. Wow…that made the timing a lot worse.
How can you tell how much working capital your business may need? The best place to start is to look at your financial statements and especially your balance sheet. How many days of receivables are you carrying and how many days of payables do you have? Are they out of balance? By how much? Furthermore, are there items that you must pre-pay, that don’t even show up in your payables? What about other items such as salaries, when do you pay them.
In order to determine how much money, you will need to adequately capitalize your business, you will need to do a weighted analysis of how long it takes you to get paid on average versus how long you have before you need to pay people. And remember that how long you get paid includes not just how long it takes your customers to pay you after you invoice them, but also how long it takes you to ship or service them after you create the product or service.
If you are like most small businesses, chances are that if you give it some effort you can dramatically cut down your capital needs. How can you do this? The first thing I would do is to look at the receivables. How can you get paid faster? Then I would look at the payables. Maybe some vendors will allow you to pay your bills slower. Then I would think about how to shorten the time from when a product or service is produced until when it is billed.
If these techniques to improve cash flow still leave you short of money, you can consider other financing alternatives. Maybe you can sell your receivables for cash, also called factoring. Maybe you can get bank financing. Maybe you can offer customers small discounts to prepay. I’m always a big proponent of trying to get customers to pay in advance. In addition to the speeding of cash flow, you eliminate the risk of not getting paid at all and importantly you eliminate the cost and hassle of collecting payments.
If all else fails you might want to seek outside equity investors. If your business is short of cash because of fast growth, but profitable growth, you should be able to attract equity investors on highly favorable terms.
About the Author:
Bob Adams is a serial entrepreneur and founder of BusinessTown.com.
- How to Increase Cash Flow of Your Small Business
- How to Manage Your Receivables
- How to Manage Home Business Cash Flow Effectively
- 7 Deadly Cash Flow Mistakes
- What is Factoring?