Many small businesses owners typically got into business seeking freedom, a better lifestyle, more money, or simply because they wanted to run their own show.
Although they possess business skills, financial acumen is rarely chief amongst them. In this article, I list the 5 most common financial mistakes.
1. Fail to plan, plan to fail
Few small businesses have a working budget and cash flow forecast that is rolled over on (at least) a quarterly basis. As a result, they make decisions based on guesswork. A solid budget requires the following information, ideally seasonalised and presented on a month by month basis:
• Sales – Your sales figures should not be just a lump sum, but broken down by product or service line and calculated as number of sales multiplied by average sale value.
• Variable costs – These are costs that vary 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.
Once you have a budgeted profit and loss account, you should then create a cash flow forecast. This differs from the profit and loss budget because it is looking at the cash inflows and outflows. As such, it needs to take account of how long your customers take to pay you, how quickly you turn over inventory, how quickly you pay your suppliers, any loan repayments due and any forecasted capital expenditure that will not appear in the budget profit and loss account.
For a thorough budget that could be presented to a bank to get financing, you should also complete a budgeted balance sheet.
2. Financing capital expenditure out of cash flow
As a general rule (if possible), it is good practice to cash flow the lifetime of a purchase. By that I mean: if you are buying stock to sell in the short term, then finance it out of your day-to-day working capital. But if you are buying a large piece of machinery with a ten-year life, then you should look to finance it over ten years.
Similarly, don’t fall into the trap of spending your money on flashy assets out of your cash flow after just one good quarter. Unless you are confident that strong sales will continue, you will be strapped for cash sooner or later.
Form a strong relationship with a bank manager and keep them up to date with your plans. Often, the banks will be happy to lend when times are good. Take advantage of this to properly finance any capital expenditure required to expand your business. Similarly, the best time to secure an overdraft is when you don’t need it. If you hit a rough patch, at least you have a safety net.
3. Failing to understand the difference between profit and cash flow
In my work with accounting firms, I admonish accountants to present financial information to their clients in layman’s terms. I recommend creating a chart to explain the difference between profit and cash flow.
I have lost count of the number of times accountants have told me that their clients love this chart. It is a simple concept, and looks something like this:
The chart depicts the open cash position of the business on the left hand side; it then adds the profit for the year. Most small business owners see that they have made a profit on paper (in this case, somewhere in the order of $45,000) and wonder why they have zero (or as in this case, negative) cash in the bank by the end of it.
This chart demonstrates why that has happened. It accounts for non-cash items such as depreciation. It then looks at ‘below the line’ items such as dividends or owners’ drawings. Importantly, it then takes account of moves in inventory, accounts receivable and accounts payable.
For example, if your customers on average are paying you 14 days slower than they were last year, your cash flow will suffer. Other items such as the capital element of loan repayments (not shown on the profit and loss account) are displayed, leading the reader down to the closing cash position. Armed with this information, you can implement strategies to improve your cash position in each area.
4. Cutting costs rather than driving revenue
When considering how to improve profitability, many business owners resort to tackling costs. That’s all good, but there is a finite limit to which expenses can be cut – zero.
On the other hand, the opportunities to grow revenue, assuming you manage your growth within the constraints of your cash flow, are limitless. It comes down to understanding the drivers of revenue, which in most businesses are:
• Number of customers
• Number of times those customers buy from you
• The average sale you make each time a customer buys
Once you understand the drivers, you can put in place strategies to increase each of those critical measures.
5. Running your business from a spreadsheet
Of all of the mistakes listed, this is quite possibly the most important to avoid. In this era of cloud accounting solutions it’s so easy to get accurate financial information especially with integrated bank feeds connecting your accounting software with your banks.
Failing to take advantage of such information is like running the business by the seat of your pants. Yet many small businesses persist in keeping their records in a spreadsheet or worse, in a shoebox!
Talk with your accountant today if you feel that your accounting records are inaccurate, unhelpful or obsolete. In fact, a proactive accountant can help you avoid all five of the key financial mistakes I have outlined in this article, helping to set you up for more profitable days ahead.