Profitable businesses don’t fail, right?
There are many reasons why even profitable enterprises don’t survive. One of the top reasons—shown by years of studies—is that they simply run out of money. They can’t pay the bills on time or make payroll, so they go out of business.
How is this possible?
Typically, running out of cash is the result of either:
- raising insufficient capital, or
- poor cash flow management.
Here’s why those two things can lead to bankruptcy, and how you can stop it from happening in your own business.
Raising insufficient capital
Raising insufficient capital means that the founders didn’t secure enough financing before starting their business.
This usually happens because the business owner didn't make a proper business plan with detailed financial projections. Entrepreneurs tend to be optimistic types; therefore it's easy for them to underestimate how long it will take to gain traction in the market. So they start up without enough money to see the business through to the point that positive cash flows outstrip negative ones.
At HPC, we help our clients avoid this situation by sitting down with them to make a proper business plan and financial projection, and figure out just how much capital is needed for the business to succeed.
Poor cash flow management
Most small business owners have no idea what their current ratio is (current assets divided by current liabilities). The current ratio measures the firm’s ability to pay off its short term liabilities with cash and other current assets.
Without keeping an eye on the current ratio, it's easy for business owners to take on more and more short term debt to expand or just keep the business running, not realizing that they'll have no way to make the required payments.
This is particularly dangerous when the debts include payroll tax liabilities, which can't be discharged under bankruptcy (in the United States) and for which the owner and other responsible persons in the organization may be held personally responsible.
Business owners need to be looking at more than just the balance in their bank account. They need to be looking frequently at their financial statements. At HPC, we reconcile the books weekly in Xero, and we provide monthly management reports (and advice). One of our top goals is to help our business owners avoid overextending their businesses.
Some great news for accountants and small business owners is that cloud accounting technology is making it easier and easier to produce key cash flow reports on a weekly or even daily basis. And small business accounting software is starting to include some of the analysis tools that are critical for understanding how the business is doing.
For example, Xero, our accounting software of choice, now has a Business Performance Dashboard, which includes charts of important metrics (such as the current ratio) that we can embed on our clients’ Xero home page. Just being able to put the current ratio front and center for our clients helps us help their businesses survive and thrive.
Interested in building or revising a business plan with HPC? Contact us today to schedule your free consultation.
Featured photo courtesy of Ken Teegardin.