“How to Avoid a Cash Crunch”

Overview

Most entrepreneurs are optimists. They figure if they manage their business carefully, then the only way they'll face financial distress is if something happens beyond their control like a recession or natural disaster.

All too often, though, business owners stumble into a cash-flow crisis by making misguided decisions, allocating resources poorly or ignoring early signs of trouble. When they assess the damage later, they realize that the whole mess was entirely preventable.

By training yourself to recognize the warning signs of financial distress — and knowing what corrective action to take — you increase your business's ability to overcome obstacles and attain fast growth with minimal risk.

In this Quick-Read you will learn:

• Three common financial pitfalls that emerging-growth entrepreneurs face.
• How to raise efficiency and lower receivables so that you plug financial holes.

Solution

Once you commit to fast growth, it's tempting to pull out all the stops; but a growth-at-all-costs mentality can backfire. When entrepreneurs experience financial distress, it's usually caused by one of three problems:

1. Courting customers blindly. In your determination to beat last year's numbers, you may say yes to customers — prematurely. Examples: You extend credit to a buyer without conducting due diligence first, or you hastily promise to fulfill a big order that proves financially crippling.

   Say you readily accept credit after a quick scan of a customer's references. The result? You may struggle to collect payments later. Solution: Contact credit references; hire a credit bureau to run a check; and if your customer is a corporation, contact its bank, a few of its customers and Dun & Bradstreet (800-879-1362) to investigate past payment history. Credit reports on commercial enterprises can be purchased from Experian (formerly TRW) and from Dun & Bradstreet. Typical costs are about $40 for an Experian report and $70 for a D&B report on a U.S. company. Credit reports have cryptic notations, so it may be useful to consult with someone who deals in commercial credit to interpret a report, for example, a banker or accounts receivable manager.

   Some entrepreneurs win major accounts and then panic as the costs of delivery exceed their projected profit. Solution: Plan how you'll fulfill huge orders so that you don't rush to secure last-minute financing at unfavorable terms. Also ask the customer for at least a one-third deposit up-front, and arrange for three alternative sources of financing, such as establishing a credit line with your bank before you need it.

2. Provoking the IRS. Running afoul of tax authorities often leads to financial hardship. Take employee withholding taxes. Some entrepreneurs raid the money allocated for their payroll taxes in the hope that they can replenish the employee trust fund once clients pay them later. This creates a dangerous precedent: missing IRS payments means even larger bills come due later

   To guard against financial meltdown, keep your employment taxes in a separate account or use a payroll tax service to handle the paperwork and keep the IRS at bay. Also beware of misclassifying employees as independent contractors; while you'll skirt payroll taxes in the short term, you may suffer a cash crunch when the IRS finds out and imposes steep fines.

3. Ignoring depreciation. Don't get too focused on your bank account and assume you're making money simply because you're not burning up cash. If you depreciate your office computers, you may think you earn a higher profit than you really do. Depreciation of equipment isn't a cash expense; you don't pay for it in today's dollars. That makes it easy to overlook. But you may need to replace high-tech machinery in a few years. Depreciation helps you prepare financially for such major capital expenditures.
   
   A more insidious sign of financial distress is runaway expenses. A fast-growth firm can incur steep operating costs, from installing and maintaining new computer systems to hiring employees. If you go without a paycheck for a year or more without a sound business model and long-term plan in place, you may be digging yourself into a financial hole.
   
   Finally, if you collect receivables too slowly, suffer from bloated inventory or pay cash on delivery rather than negotiating credit with vendors, you may eat up precious working capital rather than conserve it.

Real-Life Example

For Carey Michaels, president of Finish This Inc., a post-production company in Hollywood, Calif., opening a $30,000 line of credit with a bank convinced her to get her firm's financial house in order. In her second year in business, she had generated $150,000 in business with overhead costs of $30,000 a month. Rather than bill clients promptly, she let it slide.

"I had to pay my three employees, but I wasn't getting the billing done so the receivables weren't arriving in a timely fashion," she says. "I hate paperwork. I would do the smaller invoices, because there were no expenses to track. But the big ones didn't get done, and we were soon overextended."

Her solution? Boost efficiency by creating templates for the five most common types of invoices. After she coded them and taught her bookkeeper to prepare them electronically, she no longer had to write each one from scratch. She also learned that by billing some clients for half of her services up front, she could reduce her receivables.

Do It

1. Research your business cycle. Chart seasonal changes in activity so that you can plan accordingly. It's much easier to get a bank loan to cover a short-term cash crunch if you can predict it six months or a year in advance.
   
   
2. Avoid commingling personal and business debt. Example: Don't secure your home to pay business debts.
   
   
3. Incur debt only if you know how you'll service it. Set a realistic timetable to pay it off, rather than using debt to stay afloat without a long-term recovery plan.
   
   
4. Track turnover rates systematically. Keep statistics on three key points in your business's cash cycle: when you buy inventory, when you sell it and when you get paid for it. Strive to stabilize these numbers over time — or even improve them slightly. If they're ballooning, that's a red flag.
   
   
5. Don't confuse strong sales with strong profits. Confirm that your sales growth flows from profitable business with expense control measures in place.
   
   
6. Consider offering customers a discount for quick payment, or for advance payment. Some will be happy to pay early for a small price break. Similarly, add a penalty for late payment, to discourage delinquency.
   
   
7. Never miss an IRS filing deadline, especially if you lack cash to pay taxes due. Your financial distress will worsen once the IRS imposes penalties. It's better to complete the return, file it on time and attach Form 9465 (Installment Agreement Request).
   
   
8. Insure your business against catastrophe. Find guidance in the Edward Lowe Foundation Quick-Read Solution "Shopping for Business Insurance."