As a strategy and finance turnaround consultant, I have worked with many companies in crisis – usually one triggered by cash flow problems. The company’s bank account is heading toward the red and the business owner wonders how to meet future expenses.
Cash flow crisis require fast action and the first step is to look closely at the financial statements. The income statement and balance sheet provide vital clues about cash flow and all the business practices that influence it. Within a short period of time the financial statements can tell me a story about the company—the good, bad and ugly!
Drilling Down on the Truth
When I speak with the owners, the perceived reason for the crisis is always the same. It is the result of a recent decrease in sales due to some market-driven event, such as the loss of an account, entrance of a new competitor, etc. "If I could simply replace the missing account and ramp up sales, we would be fine," the business owners tell me.
However, their financial statements tell a different story. While it is true that a drop in sales reduces the company's available cash, this event is not the root cause of the problem. There is usually a deeper problem in the business model, which can include the price and payment terms charged to customers, cost to produce, amount of overhead or any combination therein.
I am often asked how an underlying structural problem goes unnoticed for so long. The answer from an accounting perspective: Unearned Income and Unpaid Expenses. In other words, the company survives on cash received, but not yet earned. Deposits or pre-payments received from customers prop up the bank balance – and when that is not enough, the company simply slows down payments to vendors. Sadly, with the loss of new sales to cover past expenses, this small problem mushrooms into a real cash crisis.
Looking for a Consistent Story
How do I know that the cause of the problem is not only sales related? When business results are recorded correctly, the balance sheet and the income statement work together to tell two sides of the same story. Sometimes, however, they seem to tell very different stories, which indicates a problem with the internal accounting processes and makes me question the underlying business model.
Incorrect accounting processes are more common in smaller companies which lack financial sophistication. Often the liabilities on the balance sheet are understated. For example, a small business may call customer deposits “sales”. In fact, until they are fully earned, “deposits” are correctly considered “unearned revenue” and should be a liability on the balance sheet (and not income). Likewise, vendor bills and/or unpaid salaries should be liabilities as well. If the company accepts deposits and/or incurs vendor bills these accounts should be on the balance sheet.
If the accounts are not listed or the numbers simply do not make sense, this throws up a red flag for another possible problem: The income statement may be incorrect. (e.g. If the company is counting “deposits” as “sales”, then income and profit will be overstated.) The company may not be as profitable as perceived to be, and that creates all kinds of other questions about why. I have just opened Pandora’s Box!
What does this all mean?
In simple financial terms, a cash flow crisis is looming if the profit from the sale of a product or service does not cover the cost of operations and allow adequate profit for reinvestment in the company. A short-term slowdown in sales reveals just the tip of the iceberg. When the underlying financials are not in balance, a cash flow crisis is inevitable.
To solve the problem a company must increase the selling price, decrease the cost to produce, or cut overhead cost (or a combination of all three)… and record their business results correctly in order to measure these key items. Simply adding a new account using the same pricing/cost methodology will not solve the underlying problem.
Dedicated to your success, Lori Williams
Guest blogger Lori Williams is an adjunct professor at the Lloyd Grief Center for Entrepreneurial Studies at the University of Southern California. She is a well-known business consultant, speaker and writer, and the founder of www.BusinessSimplyPut.com, an online resource for business information and advice. Business Simply Put offers eBooks, Financial Tools, Webinars and Videos designed for start-ups and small businesses. Her posts also appear on StartupNation.com