The initial years for any business are very crucial for the long-term success, with many challenges to overcome and lessons to be learned.
Challenges related to cash flow and mismanaged finances are primary causes of business failure in the early years. Some companies don’t plan properly, some don’t keep track of costs properly and some fail to chase outstanding payment.
One can maximize profits and ensure the firm’s success by being aware of the pitfalls. Taking thoughtful and practical steps will help you control overspending and grow your business without taking excessive financial risks.
Why Startups Struggle with Cash Flow Problems
The initial years are very challenging for a firm to make good sales and its termed as the pre-trading period. In these periods, there are constant costs incurred without any significant profit in hand.
A new business usually has to spend up-front on marketing, advertisement, promotions and product research and development. Also, suppliers make some pressure by asking for the early payments. A start-up business can’t be expected to have reserves of cash made out of profits which we call as “retained profits“.
Therefore, during the initial months, it becomes important for a startup to have a good practice for cash flow management else most of the start-ups go bankrupt only because of this one issue.
Cash flow forecasting as an important tool for start-ups
For a small business, cash flow is a lifeline. So, one can always predict by looking at your cash flow status that your business is going to live or die.
- Predict cash-flow shortfalls for future– If done accurately, the cash flow forecast act as an early warning sign.
- Firm’s debt status- It reflects how fluidly a firm is able to make payments to its suppliers and employees.
- Loopholes in customer payments – Now, to look at the other side, a firm should also know how quickly it’s getting paid by the customers… Exceptions- this is not applicable for businesses (like retailers) that have most of their sales cash/credit cards at POS.
- Assists effective financial planning – Forecasting cash flow is an integrated management process and aids in preparing business budgets.
- External stakeholders- If the firm has taken a bank loan for their business, the bank will require looking at cash flow forecasts regularly.
Limitations of Cash Flow Forecasting for a Startup
Every technology or process has some limitations. One can’t always rely on them majorly because businesses need to make assumptions about the future. Following are the reasons that cash-flow techniques might not always prove to be accurate:
Overestimation of sales
It is too easy to make optimistic assumptions about sales before the business starts trading. How much ever promotions or marketing is done and potential customer base is built, one can’t be sure of actual sales unless it starts happening.
Customers do not pay up on time
Businesses let their customers buy goods/services on credit many times. Many small businesses get impacted by the delayed payments made by customers. Many times, small business waits 30-60 days before invoices are settled and even much longer in some cases.
Under-estimation of raw materials and other inputs costs
This can happen in several ways. For example, the business may underestimate the price that has to be paid for each supply. Alternatively, the number of raw materials required may be under-estimated, perhaps because the production process doesn’t turn out to be as efficient as expected.
Hidden costs( Petty costs)
For a start-up, everything is a new experience and they don’t have an idea of a specific market. So, they may face a lot of costs which they never thought will levy.
What should be an entrepreneur’s response to deal with the mentioned limitations?
A good way is to create two different versions of the cash flow forecast:
- (1) A “base case” version – Expected version
- (2) A “downside” or “worst case- Pessimist version
- Which forecast should be used? It depends on who is reading it. The bank manager is probably best given the “downside” version so that his/her expectations are managed.
One can follow the below steps to deal with the cash-flow related challenges:
Step 1 – Treasury Management Checklist
The primary thing to keep in mind is that cash should be reconciled daily without an exception. Also, one can draw the line of credit daily too. The key is to maintain and keep a check daily. You can refer to the sample small business treasury management checklist we have created for you:
Step 2 –Update rolling cash forecast regularly
Cash forecasting is a great tool in knowing the possible scenarios of cash deficiency in the future. It can help us decide whether we can meet payroll at month-end and our receivables balances will not be disturbed and rolled into cover the expenditures.
Forecasting is a challenging job and they can’t be perfect due to certain limitations, of course. But it’s better than marching ahead towards your goal without the clear direction.
Step 3 – Optimize working capital
The goal is to never have a past-due account. But when you find that you have, take it seriously. Most of the businesses fail to give this important and the same goes for inventory. Inventory management might seem like a super complex process but a streamlined inventory aging schedule weekly, looking for old inventory not moving, might help. But look for inefficiencies too. Are your best-movers moving as fast as possible? So find ways to optimize your best products.
Step 4 – Get a Handle on the Big Picture
At least one time annually, its best to look 12 months out on a macro basis. In short, what’s the harm in getting a handle on earnings, changes in working capital, capital expenditures, payments on term debt, and any other major uses (or even sources) of cash? And what a great roadmap it is. The forward-looking view helps in spotting potential cash challenges.
The only thing which stays constant is the change. The financial plans should be flexible enough to change too. One should do a basic forecasting of their business and while doing so, be realistic and try to estimate how much you will sell and how much you will spend. Include these numbers into your financial plan and monitor the result until you feel that they will still work for your business. If it isn’t happening, be ready to update the plan.