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, so how can they make justifiable financial decisions?
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.
With this information you should then create a cash flow forecast. This takes into consideration other cash inflows and outflows and 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. From this you can create a forecast balance sheet, that will most likely be required if you need 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?’
There are many different scenarios that could cause this, but in most circumstances’ decisions are being made with reference to ‘book profit’ without properly understanding how cash flow can differ – sometimes quite significantly – from profit.
Another reason for this could be down to the payment terms you have with customers. 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. That’s where we come in.
We have the skills to help you avoid all of these mistakes and we’d be delighted to talk with you about strengthening your financial reporting processes so that you can make more informed business decisions. Contact us today to find out more or follow our LinkedIN page to stay up to date with our business.