Three Financial Mistakes Made by Many Businesses
Many of our clients tell us that they got into business to make more money, achieve a better lifestyle or simply because they felt they could do a better job than their old boss.
Although many do possess business skills, financial acumen is rarely high among them. In this article, we list three common financial mistakes that we observe frequently.
1. Fail to plan, plan to fail
Not enough businesses have a working budget and cash flow forecast that is frequently updated and compared to actual results. Consequently, they make important financial decisions without all of the information that they need. A strong budget requires the following information, presented on a month by month basis and adjusted for seasonality:
- Sales – Your sales forecast should be broken down by product or service line and calculated as number of sales multiplied by average sale value.
- Variable costs – These are costs that go up or down in line with sales and, as such, should be driven by your sales forecast.
- Fixed costs – Unless there are any significant changes, these can be taken from your most recent financial statements and adjusted for any known or expected increases. They are the costs that you incur irrespective of sales volume.
Once you have a budgeted profit and loss account, you should then create a cash flow forecast. This differs from the budgeted profit and loss account because it takes into consideration other cash inflows and outflows. As such, it needs to take into account of how long it takes for customers to pay you, how quickly you turn over inventory, how quickly you pay your vendors, any loan repayments due and any forecasted capital expenditure or drawings that will not appear in the budget profit and loss account.
With this information, a forecast balance sheet can be created, which will almost certainly be a requirement should you require finance from a bank.
2. Financing capital expenditure out of cash flow
As a general rule, it is good practice to match cash flow with the lifetime of a purchase. For example, if you are purchasing inventory to sell in the short term, then you should use day-to-day working capital. But if you are buying a new delivery truck with a five-year life, then you should aim to finance it over five years.
Similarly, don’t fall into the trap of spending your business’s money on impulse purchases out of your cash flow if you have one good quarter. Unless you are confident that strong sales will continue, you could be digging a hole for yourself if sales regress back to prior levels.
3. Failing to understand the difference between profit and cash flow
One of the most frequent questions we hear from our clients is, ‘I can see there is profit in the accounts, but I have no cash in the bank – what’s going on?
What is typically happening in that scenario is decisions are being made with reference to ‘book profit’ without properly understanding how cash flow can differ – sometimes quite significantly – from profit. For example, excess drawings by the business owners do not appear in the profit and loss account, but they clearly drain cash. Also, you might close a big deal with a major customer and book the revenue as sales, but if they don’t pay you for 90 days, you could find yourself in a tight spot. Similarly, you might commit the business to a large loan to finance new machinery, but the capital element of the loan repayments will not show up on the profit and loss account.
Solid financial reporting can improve decision making by demonstrating the difference between profit and cash and forecasting the cash position over the next few months.