Why Startups Struggle with Cash Flow Problems
Start-ups and small businesses are especially vulnerable to cash flow problems. Here are some of the main reasons:
It can be a while before the business makes its first sales – the pre-trading period often involves incurring costs without getting any revenue in return
Suppliers may demand immediate or early payment from the start-up as the business has not developed a track record for paying bills on time
A new business usually has to spend up-front on expenses such as marketing and product development.
The new business will not have reserves of cash built up from profitable trading – an important source of cash known as "retained profits".
During the early months of trading, therefore, a start-up business faces its most significant challenges in managing cash flow. Without careful management and planning of cash, the business may run out of money. You can probably see why cash flow problems are a major cause of business failure amongst start-ups.
Why Cash Flow Forecasting is Important for a Startup
Cash flow is the life-blood of a small business. So you can probably seen that it makes sense for a start-up to forecast (predict) what is going to happen to cash flow to make sure it has enough to survive. If a business runs out of cash and fails, then it would be a shame if the entrepreneur hadn't at least seen it coming.
Identify potential shortfalls in cash balances in advance – think of the cash flow forecast as an "early warning system". This is, by far, the most important reason for a cash flow forecast.
Make sure that the business can afford to pay suppliers and employees
Spot problems with customer payments – preparing the forecast encourages the business to look at how quickly customers are paying their debts. Note – this is not really a problem for businesses (like retailers) that take most of their sales in cash/credit cards at the point of sale
As an important discipline of financial planning – the cash flow forecast is an important management process, similar to preparing business budgets.
External stakeholders such as banks may require a regular forecast. Certainly if the business has a bank loan, the bank will want to look at cash flow forecasts at regular intervals
Limitations of Cash Flow Forecasting for a Startup
It is important to remember the limitations of a cash flow forecast. They are not always reliable, largely because businesses need to make assumptions about the future. When commenting on any cash flow forecast in the exams, take a look at which figures are estimates and try to assess whether the entrepreneur has built in some contingency or safety margin.
Common reasons why cash flow forecasts prove unreliable include:
Sales prove lower than expected
It is too easy to make optimistic assumptions about sales, particularly before the business starts trading. Market research may help an entrepreneur estimate potential sales volumes and prices that customers will find acceptable. However, there is no substitute for actually starting to sell. Only by trading does the entrepreneur discover whether the product is attractive to customers, the price they will pay and what seasonal and other factors actually affect demand.
Customers do not pay up on time
This is an issue for businesses that allow customers a period of credit before paying for their purchases. Many small businesses suffer significantly from slow or delayed payment by customers. It is not unusual for a small business to have to wait 30-60 days before invoices are settled – sometimes much longer.
The cost of raw materials and other inputs prove higher than expected
This can happen in several ways. For example, the business may underestimate the price that has to be paid for each supply. Alternatively, the quantity of raw materials required may be under-estimated, perhaps because the production process doesn't turn out to be as efficient as expected.
Certain costs are not included
A common problem for start-up, particularly if the entrepreneur does not have experience of the market in which is it launching. New entrepreneurs are often surprised by the type of costs that a small business incurs, often unexpectedly high.
Given the limitations of cash flow forecasting outlined above, how should an entrepreneur respond?
A good way is to create two different versions of the cash flow forecast:
- (1) A "base case" version which is the expected or hoped-for version
- (2) A "downside" or "worst case" version, which takes a pessimistic view of what might happen.
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.
Sources of Information to Help a Startup Forecast Cash Flow
The main sources for the assumptions used in the cash flow forecasts for a start-up will be:
Entrepreneur experience – there is no substitute for experience of running a small business. Some of the assumptions will be based on "gut feel" and instinct. A cash flow forecast produced by an inexperienced entrepreneur has to rely much more heavily on other sources.
Market research into key aspects of sales and costs – e.g. seasonal fluctuations in demand, average selling prices and quantities in the market, typical gross profit margins, the lead-time between marketing campaigns and orders etc
Suppliers – a great source of information on costs and also the timing of payments. What are the industry norms for paying suppliers in the market?
Advisers – it makes sense for start-ups to get help from advisers when putting the cash flow forecast together. The advisers might be from Business Link or other government-funded agency. It could also be the local bank manager or accountant – whose help is particularly useful when it comes to making sure the forecasts are complete & mathematically sound.
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