Do you recognize this scenario? A small business owner is having a cash flow problem. Maybe there were cost overruns on construction to expand space. Maybe the high season wasn't as high as usual. There are a thousand reasons, right?
The business owner takes out a business loan. Gets out from under the immediate cash crunch, but soon finds a new set of overdue bills and looming costs rushing forward. Why? Because nothing about the business changed. The loan was used to plug a hole. The causes of the cash flow squeeze were ignored. Well, time to find another business loan to plug the new holes.
Now the small business owner is paying on the first business loan, and has just added new payments on the second business loan – all while still suffering from the original business mistakes that started the cash flow problems in the first place.
Call it the debt spiral, where continually increasing debt costs burden and eventually strangle a business. When I'm feeling less charitable, I call it being a business loan junkie. The lure of "easy money" can be intoxicating. Then you wake up. If you don't get out of it, eventually you'll hit rock bottom – losing your business.
Some business owners who regularly take out loans may be in denial about their habit. They only carry one loan at a time – so no debt spiral, right? Wrong.
If your small business needs to regularly look for outside funding to operate, you're not operating a successful business that can support itself.
I'm not saying that needing a business loan or extra capital from time to time is bad for a business. Far from it. Over half of small businesses have had to find outside funding in the past five years. They use the money to hire more staff, buy more inventory or new equipment, and yes – address temporary cash flow challenges.
Here's the key question to finding out if you're a business loan junkie: Are most of your would-be profits going to pay off debt? Then it's not really profit, is it?
Profit is money you can reinvest in your business so it can expand. Profit is money you can use to reward your current staff. Profit is money you can take out of your business for a bigger house, better vacations – whatever you enjoy spending money on.
You can see now that carrying too much debt brings business costs well beyond the actual amount of money being paid to carry it. There are opportunity costs as well.
So there's good debt and bad debt. Good debt is money you use to enhance your business. Bad debt is continually borrowing more money because the business can't operate without it. I want you free from bad debt. I have my reasons; I want you taking on good debt at the right time to grow your business where it makes financial sense for you to do so.
That's why I want to help any business loan junkies out there get out of this cycle. In this post, I'm going to go over:
- Typical bad practices that result in cash flow problems
- How to avoid these bad practices
- How to get out of the business loan cycle if you're already in it
7 (or so) Common Causes of Cash Flow Problems
In some cases, cash flow problems result from structural problems in the business. These are the most serious cash flow causes and those most likely to result in a closed business.
- Bad pricing
You're meeting the sales and revenue expectations of your business plan, but still struggling. Now, maybe your goals are too low. It's more likely that you’re pricing your goods or services too low. If you're in a highly competitive arena like a restaurant or salon, trying to gain market share through low pricing is a common tactic. It may even succeed in the short term. But who cares how many customers you're serving if it's costing you money to serve them?
- High overhead
If you took out the first loan to cover your operating costs and then didn't work on reducing those costs, you may be a business loan junkie. Finding where and how to reduce operating costs can be difficult since each industry and each specific business has its own operating quirks.
Even so, your industry may have some obvious places to look first. If you're a restaurant, how much food are you throwing out each night? Does your provisioning process need a review?
Labor is a huge portion of any business's budget. Are you overstaffing?
Other cash flow problems come from bad financial management.
- You don't have a good handle of your costs or revenue cycle
It's amazing how many small business owners don’t actually know how their cash is literally flowing in and out of their accounts. They're not paying attention when their bills or invoices are due, and how they align (or not).
Do your bank reconciliation each month to get the true picture. If you're in a business with a long invoice cycle, like construction or a medical practice, look at when payments are actually coming in. Even if you are able to stagger your invoicing, this only creates the theoretical possibility that cash is constantly coming into your account. You need to look at how long it's actually taking people to pay them.
- You have sloppy invoicing
Sloppy invoicing can mean lots of things. It can be not sending them out in a timely way. If your back-end administration isn't what it should be, are you under-billing? Are your invoices hard to read or inaccurate, so delaying payment? Do you fail to follow up on late, outstanding invoices?
- Your invoice and billing cycles are out of sync
I hinted at this in bad cash flow cause #3. If the bulk of your bills are due by the middle of the month, but don't expect your invoices to be paid until the third week of the month – you're setting your business up to have a constant cash squeeze.
- You take on more debt than you need
This one really bothers me. Let's say you need a $50,000 business loan to buy extra inventory in time to meet an expected boost in demand. You qualify for a $75,000 business loan. You take out the $75,000 business loan.
Why? You estimated $50,000 in additional inventory because that's what you determined your market would demand and your operations could supply. Did something change? If your predictions were accurate, what are you doing with that other $25,000?
If you used it all to buy inventory, now you're sitting on excess inventory – another common cause of cash flow problems. You're paying to store that inventory or it's taking up space where you can't put new inventory.
If you used that other $25,000 for something else, how rash was that decision? Did it make sense for your business to make that expenditure at that time?
I'm going to start my "how to avoid cash problems list" with this one, but it's important enough to state twice: Don't borrow more than you need.
If a new need comes up in the future consider another business loan at that time.
- You don't or can't respond to changing external conditions
When you started, your gross margins were good. You had control of your costs and were charging a fair price for your goods and services. Then things changed. Your high and low periods have changed, but you haven't re-aligned your billing and invoicing cycles. The cost of coffee or cement spiked.
Some of these external changes can be temporary, but you aren't liquid enough to weather them because you don't keep a cash reserve. Others are long term shifts or even the new reality, but you aren't making changes in your own operations and overhead to accommodate them. Now you find yourself suffering from cash flow squeeze due to structural flaws in your business (see items #1 and 2).
Tips for Avoiding Cash Flow Problems
I've been dropping some of these tips throughout the discussion on causes. In case you missed them, here they are again – along with some other tips.
- Don't borrow more money than you need.
- Understand your financial statements and how to read them.
- Make sure that your business plan forecasts a gross margin that would result in a profitable business.
- Stay in control of your overhead costs and cut them if necessary. Understand what you're actually spending to operate your business.
- Invoice intelligently and have a clear, follow up process to handle the late ones.
- Set up your invoice and billing cycles so they aren't out of sync.
- Account for quarterly or semi-annual bills you have to pay on a monthly basis by pre-paying them into a reserve account (not your emergency reserves). If your insurance bill is due every six months, pay 1/6 of it out of each month's receipts into a separate account. Now you don't have to sweat the larger payment and you may have earned a little interest on the side.
- Set aside cash reserves you can rely on in a pinch. If you have to use some of your reserves, replenish them.
- Don't ignore changes in external conditions – they will affect you. You can either be overtaken by them or ride them into growth.
Business Loan Junkie Rehab
Alright, let's say you're already carrying too much debt or are a full rank business loan junkie. This doesn't mean you'll inevitably lose your business. You've already taken the first step – acknowledging you have a problem.
The second (large) step is to start the process of addressing the underlying cash flow problems that your series of business loans is just papering over. We already know that taking on too much debt is one of them. I'll get to that in a minute.
Be brutal in your analysis. Bring in outside financial and business counselors if you need help either with conducting the analysis or being honest about the changes you need to make, or both.
Now, let's look at your business loans themselves. If you're currently carrying multiple business loans, it may make sense to consolidate them into a single business loan. This way, you don't have to go through the stress and expense of re-negotiating multiple loans. You'll also lower your administrative overhead of remembering which loans are due on which dates, and end the struggle to adjust your revenue cycle to keep up with them.
SBA loans can be used to pay off high interest loans and will bring with them lower interest rates. Some states provide better access to SBA loans, than others. SBA loans also typically require at least a fair credit score (650 or up). If you can qualify for an SBA loan, that could be a good choice.
If you don't, you have other options to clear your current business loans, such as a bad credit business loan or unsecured business loan. If your business does a high volume of credit card sales, you may qualify for a merchant cash advance.
Another step you can take to help stop the bleeding is to find a good business credit card, especially one that has a zero interest grace period. I don't recommend using the credit card to pay off your outstanding debt because the zero interest won't last more than a year, after which you'll be paying a higher APR on credit balances than you're likely paying on the loan. If you have just a small business loan balance outstanding, it might work.
But the value of the zero interest business credit card isn't paying off your current debt. It's about keeping you from needing to take out additional debt to cover operations while you get your house in order. The zero interest period, typically between nine to 12 months, is just a temporary breathing period while you go through the hard work or finding and fixing your cash flow problems. A lot of these cards also offer cash back, which is helpful in shaving a little off the top of your operating costs.
Most of these steps should also help you improve your credit score, assuming you make timely payments on the consolidated loan and/or zero interest credit card. That will help bring the cost of future borrowing down.
Of course in the future, you're only going to borrow what you need to execute a solid expansion plan or as part of a process (and not just being a band aid) of fixing some cash flow problem, right?