The Cash Flow Problem
Background
The Cash Flow Problem and Its Causes
a. Primary Causes of Cash Flow Problems
b. Further Causes of Cash Flow Problems
Resolving Cash Flow Problems
a. The Receivables Conundrum
b. Multiple Actions to Resolve a Cash Flow Problem
Final Comments
Background
Perhaps no business problem is so well known to small-business owners and so little known to the public (including policy-makers) as cash flow. Just as the three basic rules in real estate are ‘location, location, and location,’ the three basic rules in small-business management are ‘cash, cash, and cash.’ What makes this simple idea so difficult to understand is that people often confuse cash with other business assets. People assume that the two are synonymous and they are not. While cash is an asset, it is only one kind of asset. Buildings, land, vehicles, machinery, furniture and fixtures are examples of others. But cash is a very special asset because only cash can be used to make payroll, cover bills, and pay taxes. A small-business owner cannot pay an employee with a desk (a business asset) or creditors with a warehouse full of inventory (also a business asset) or tax collectors with the latest computer. Employees, creditors, and government demand cash. In addition, cash must constantly be available, at times often not of the owners’ choosing and seemingly never when convenient. Small-business owners, therefore, must always have access to it. This edition of the National Small Business Poll focuses on the reasons for and the reactions to The Cash Flow Problem.
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The Cash Flow Problem and Its Causes
While cash flow ranks near the top in the hierarchy of small-business problems (third in NFIB’s Small Business Problems and Priorities as an example), the condition of individual segments of the small-business population varies notably. Nineteen (19) percent indicate that cash flow is a “continuing” business problem (Q#1); 14 percent term it a “common” problem; and, 33 percent say that it is an “occasional” problem. In contrast, another 33 percent assert that cash flow is “never” a problem. Looking at the issue from a different perspective, about one-third of the population has a frequent cash flow problem; one-third encounters it from time-to-time, and one-third never finds cash flow an issue.
One common but erroneous assumption is that cash flow problems arise only in the smallest businesses. In fact, they appear in small businesses of all sizes. Twenty-three (23) percent of those employing 20 or more people have a “continuing” problem compared to 18 percent among the 10-19 employees size group and 19 percent in the 1-9 employee category (Q#1). But there are businesses in certain industry segments that are more and less prone to the problem. Small-business owners in the financial services, for example, face cash flow problems relatively infrequently; manufacturers face them relatively often.
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a. Primary Causes of Cash Flow Problems
Small-business owners experiencing cash flow problems most often feel that the primary reason for the trouble is associated with the difficulty collecting money owed them. Thirty (30) percent say that outstanding receivables are usually the primary reason for their cash flow problems (Q#2). If they could collect the money owed them more quickly, presumably the problem would occur much less often. This surprising response raises an obvious question: why aren’t more receivables collected before cash problems arise? A more vigorous collections policy might avert a problem in the first place. The data gathered for this report offer no clues for the reason(s) receivables are not pursued more avidly, but they do suggest that small-business managers who extend customers credit often need to more carefully manage this aspect of their business.
The second most frequent source of cash flow problems is seasonality. Twenty-three (23) percent say that seasonality is their primary reason for a problem. Seasonality is a familiar situation to many businesses. A classic example may be the small retailer who must watch cash flow out the door as he builds inventories for the back-to- school season; only later does the flow reverse itself (hopefully) with cash coming back into the firm as seasonal sales are made. But seasonality can affect businesses as diverse as home-building, tourist lodges, and accountants.
While 23 percent associate their cash flow problems primarily with seasonality, the proportion of seasonal businesses is smaller than might be expected. Seven percent claim that their sales are concentrated in one quarter of the year (Q#7). Another nine percent say that their sales occur largely within a six-consecutive month span. Totaling the two means 16 percent or about one in six businesses have a heavy seasonal component. Thirty-four (34) percent describe their sales pattern as “lumpy” with strong and slow periods scattered throughout the year. These are not necessarily seasonal businesses, but share the condition of irregular sales. Almost half (48%) stand in contrast with sales that are evenly spread. Just 14 percent of this group report that cash flow problems are “continuous” compared to 40 percent who say that they “never” have them.
Seasonality is not confined to a particular quarter or series of months. The “season” can occur any time during the year (Q#7a). In fact, “one-quarter seasonal” businesses tend to have their “high” season in the third or fourth quarter with the third being the more frequent. “Two-quarter seasonal” businesses are very different. About 40 percent begin their “season” in the second quarter extending through the third. The second greatest number have theirs begin in January and see it last through the second quarter.
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b. Further Causes of Cash Flow Problems
Uncollected receivables are most frequently blamed for cash flow problems and seasonality is blamed second most frequently. However, sales issues are associated with cash flow problems in more than one of four cases. Fifteen (15) percent of small-business owners generally associate a cash flow problem with unexpected variations in sales. In effect, their sales forecasts simply prove overly optimistic in light of changing conditions. This does not suggest that their sales are inherently weak nor that a forecast projected a sales increase. It simply means that actual sales cannot support the commitments made for the anticipated sales level. The cause of the cash flow problem, therefore, is a sales forecast error. The remedy is better sales forecasting, a task many small-business owners have difficulty carrying out.
The allied problem is weak sales. Thirteen (13) percent cite this trouble. Weak sales differ from unexpected variation in sales in that the former is a persistent lack of sales where the latter is a mismatch due to poor anticipation. The former implies sales levels are simply inadequate to sustain costs. The solution is generating more sales rather than rectifying the imbalance between forecast and actuality (which may mean generating more sales, at least in part).
Eight percent note unexpected variation in costs and the same number identify the need to make a large investment, i.e., front the cost, and wait for the sale or payment. Examples of the former are uninsured losses, government mandates, and unannounced price increases from suppliers. Examples of the latter are a builder constructing a house “on spec” and a designer fronting the cost of a large printing job for a client. Both imply a substantial cash outlay up-front with customer payment coming later. As a result, the severity of the cash flow problem generated is based on the time lapse between outlay and payment and the owner’s capacity to finance the outlay.
The frequency of cash flow problems and the primary reason for them appears tied in two ways. First, small employers who say cash flow is an “occasional” problem cite seasonality as the primary reason for their problem 26 percent of the time. However, when cash flow is a “continuous” problem, they cite seasonality 13 percent of the time. That difference suggests that small-business owners generally understand the nature of their seasonal problem and adjust, even if from time-to-time they are unable to adjust adequately. The result is comparatively few severe cash problems stemming from seasonality. Second, those who experience a “continuous” problem cite fronting a large cost(s) as the primary reason for their problem 14 percent of the time. Those with an occasional problem cite it five percent of the time. The implication is that fronting large costs is associated with continuous cash flow problems. Avoiding such costs to the extent possible, or at least sharing them, is an appropriate management objective.
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Resolving Cash Flow Problems
The single most important actions small-business owners customarily take to resolve a cash flow problem is to draw on personal resources. One in four (25%) identify this action as the one most important (Q#4). Thus, if the business runs short of cash, the family “cookie jar” becomes the principle source of business finance. Hopefully, the money put into the business for cash flow purpose is just a “loan” from the owner. But even if these “loans” successfully overcome any immediate cash problem, the “loan” deprives the owner of any interest or income that might accrue were it invested elsewhere. In other words, these “loans” are not free and the money is at some degree of risk.
Three other actions are also often the one most important taken to resolve a cash flow problem — borrowing, adjusting scheduled purchases, and adjusting scheduled payments. Nineteen (19) percent say their most important action is borrowing. The most likely source of loans (borrowing) to finance cash flow problems is commercial banks. Seventy (70) percent who borrow for cash flow purposes indicate that they take out a loan or draw down a line from one of them (Q#5). Other lending sources have comparatively small shares of the market. Eleven (11) percent borrow from family and friends and 10 percent from financial institutions other than commercial banks, e.g., finance companies. Seventy-two (72) percent who have a “continuing” cash flow problem also maintain a line of credit at a commercial bank compared to just 61 percent of those who never have a problem (Q#8).
Another 19 percent say that the one most important step they take to resolve a cash flow problem is to adjust scheduled purchases. They simply postpone, delay, or scale-back purchases they otherwise would make. Purchases that might be included are inventories, furniture, and machinery. One effect of these deferrals is to conserve cash, even when the “purchase” is a lease. Small-business owners presumably return to some semblance of their purchase schedule once their cash problem fades, but the interruption is an opportunity cost that never can be recovered. The data unfortunately do not address the opportunity(ies) foregone under such circumstances.
The final frequently taken one most important measure is adjusting payment schedules. Fourteen (14) percent top their list of potential actions with this step. Unfortunately, more detail is not available regarding use of the payment schedule option. Adjusting scheduled payments could mean foregoing cash discounts for early payment or withholding a planned payment prior to a due date. It could also mean a few days delay with an interest charge or otherwise changing scheduled payments without raising credit-rating issues. It could also mean “robbing Peter to pay Paul” which is considerably different than relinquishing an early payment discount. While there is no way to distinguish between those rescheduling payments without credit rating implications and those who reschedule and jeopardize it, this response is potentially the most troubling in the survey.
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a. The Receivables Conundrum
Other measures are cited as the one most important action much less frequently. However, trying to collect money due is one of the more interesting. Even though 30 percent identify the inability to collect receivables as the primary reason for their cash flow problems, only six percent identify collections as the one most important step taken to resolve it. Complicating the issue further is the fact that increasing collections activity is the most frequently taken action to resolve a cash problem (discussed subsequently). Thus, too many receivables often contributes to the problem; small-business owners move to speed collections more frequently than taking any other action to solve their problem; but the step appears relatively ineffective. The question is, why? Why is collection so ineffective as an action to resolve a cash flow problem when it is a substantial cause of it. One likely reason is that collections take too long to rectify an immediate problem. Even if a vigorous collections effort began immediately, sufficient money could not be accumulated quickly enough to rectify the problem. Therefore, while an effective collections policy is an important step preventing a cash flow problem, it does not appear to be an effective step combating one.
Other potential steps such as employee layoffs or selling receivables are rarely the one most important step taken. Though they may be used in particular circumstances, they are not basic responses when cash problems arise.
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b. Multiple Actions to Resolve a Cash Flow Problem
Small-business owners resolve their cash flow problems in many ways. Only 10 percent rely on a single action for all situations. About half of those collect receivables as their sole strategy and a smaller group employ personal resources exclusively. But most use a variety of actions. In fact, small employers use an average of over four separate actions, though they do not necessarily use each one every time a problem flares.
The most frequent action to address a cash flow problem is to try harder to collect the money owed them. Seventy-two (72) percent indicate that collections is one of the strategies commonly employed when a problem exists (Q#3F). While the action appears not to be a particularly effective means to resolve a cash problem (given so few feel it is their most important action), it is a logical response to an associated problem.
A similar percentage of owners (71%) adjust scheduled purchases when confronted with a cash flow problem (Q#3E). They simply postpone, delay or perhaps even cancel planned expenditures. If the purchase were not to be financed, then the money set-aside for it can be used to resolve the problem. If the purchase were to be financed, delay might not resolve the problem but it will not exacerbate it either. Without knowledge of the specific circumstances that surround each instance, adjustment of scheduled purchases appears one of the more obvious and advisable steps to be taken.
The third most frequently taken step is to draw on personal resources. Small-business owners dip into their personal savings and investments frequently to put cash into the business, sometimes going to the extent of formally making the business a loan. Sixty-four (64) percent say that they usually draw on personal resources to handle a cash flow problem (Q#3A). Twenty (20) percent indicate that they cash in investments held on behalf of the business (Q#3B). However, business and personal resources are usually indistinguishable, even in the corporate form where legalities create formal divisions. The result is that three of four who say that they cashed in business investments also say that they used personal resources.
The remaining steps assessed emerge less frequently. Half adjust payment schedules as a measure to address cash flow problems (Q#3D). It is common (84 percent) for those adjusting payment schedules to also adjust purchase schedules. In fact, the two steps are taken in concert 42 percent of the time.
Forty-five (45) percent say that they borrow to address their cash flow problems (Q#3C). Two-thirds that borrow also put up personal resources. Thirteen (13) percent claim that they lay off employees (Q#3G). Eleven (11) percent sell their receivables (Q#3H).
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Final Comments
Small-business owners need to avoid cash flow problems. But cash flow problems happen (for better and worse reasons), even to those whose sales are spread throughout the year. The appropriate management response is, therefore, on two levels: the first level consists of measures to avoid the problem from the beginning. The second is to resolve a problem if it occurs. The data presented here suggest that one important preventive step is to maintain an effective credit and collections policy. A surprisingly large percentage of small-business owners, 30 percent, attribute their cash flow problems to failure in this area. While vigorous prosecution of such a policy can rebound in a loss of sales, particularly when a large monopoly is the primary customer, small-business owners should at least be aware of the trade-off that they make.
Seasonal problems are also a common cause for cash flow problems. While many small-business owners have diversified their offerings and customers thereby leveling their monthly distribution of sales, seasonality often cannot be dodged. But those subject to large seasonal swings need to consider ways to stimulate activity in the traditionally slower parts of the year.
Problems caused by the inability to forecast sales changes have probably declined over the last several years due to better inventory controls. Still, accurate sales forecasts remain a vexing problem for most. Individual business owners just as often forecast their sales inaccurately as accurately. Very little attention is paid to this issue whether by business owners or their advisors, and that is unfortunate.
Other obvious techniques can be employed to avoid or at least reduce the incidence and severity of cash flow problems, e.g., having customers shoulder a larger share of large up-front costs. If they were easy to implement however, more small business owners would be employing them than they do now. A stumbling point is that such steps may have a downside making small employers reticent to undertake them. An occasional cash flow problem may even be a small price to avoid steps that ultimately may have negative sales impacts. Yet, the goal is to avoid cash flow problems in the first place.
Once a cash flow problem appears, small-business owners commonly take multiple actions to rectify it. The most frequent significant step is marshaling personal resources. But they also frequently borrow and adjust purchase and payment schedules. Such steps are necessary to resolve an immediate, and possibly threatening, problem. They all also increased costs to the business. These increased costs must be paid for in some manner whether it is through lower earnings, higher selling prices, etc. Thus, any costs incurred preventing cash flow problems must be weighed against the real costs incurred experiencing them, real costs that can become so high they destroy the business.