Avoid the Three Pitfalls Most Small Business Owners Fall Into Part 1 – Financial Management

Having coached many small business owners for over a decade while also starting up a couple of small businesses ourselves, here is what we have learned — running a small business can be fun!  However, we have observed that there are three pitfalls many business owners tend to fall into that really takes the joy out of running a business…and the numbers from Statistics Canada back this up:

One in three small businesses will fail* and most small businesses fail because of:*

  • Weak financial management
  • Weak planning and accountability
  • Weak marketing capabilities

In this post, we’ll discuss the primary weakness that can hobble your business success:

FINANCIAL PITFALLS

Don’t stop reading here…this is the important part!

What continues to upset us is that we have tried numerous times to run seminars on the basics of the financial side of running a small business – we’ve even tried to make them sound fun – but no one signs up.  Why not?  This is the most important aspect and it really is not difficult.

There are two main financial mistakes that will run your business into the ground:

  1. Failing to understanding your business model
  2. Failing to managing your cash flow

Business Model:

It is simple:  your numbers need to work.  Your business model outlines how you plan to make money and make your numbers work.  The assumption you are making is, “I will build it and they will come”.  Really?  Your job as the chief cook and bottle washer (a.k.a. CEO, CFO, President, Owner and Service/Product provider) is to clarify your assumption with numbers.

How much will it cost to build it?
Who will come?
How many of them?
What will they pay?
Will that cover the costs?

In the words of Peter Drucker, “what is the underlying logic that explains how we can deliver value to customers at an appropriate cost?”

What is your revenue source?
What are you selling?
What is the cost structure? How much will it cost you to design, build, ship, store, market and sell?
Who is your customer base and how many of them are there in your marketplace?
What will be your profit margin (revenue minus all costs)?

For a great template to help you plan your business model, for a new business or just a new product or service, check out Alex Osterwalder’s Business Model Canvas.  We love it, we use it a lot.

As well, using a pro forma profit & loss spreadsheet is handy – you can model different financial scenarios to get an idea of whether you will cover your costs and at what point (at how many sales) you might break even and start to make a profit.

Things to look out for:  

Your assumptions may be wrong.  You have to crunch the numbers.  For example, you may be making the assumption that your local marketplace (town, region, country) has enough of your target customer.

Target Customer:   the specific segment of people who would be likely to need/want and possibly purchase what you are selling. 

There might be, but are there enough who buy frequently enough to cover the costs you will incur? 

Case Study:  

We had a client who wanted to make specialty clothing for medically challenged children in her town and sell them locally.  The problem was that the number of people in that niche market in that town was not enough, given their purchase behaviours for that item, to support her costs to manufacture, ship and store a full line of clothing.  Even the region was not enough to support her costs and she had to consider that she would be marketing, selling and shipping nationally.  The numbers just didn’t work to support her original business model assumption.

Cash Flow: 

It’s shocking how many people fail to take cash flow into account.  Repeat after me, ‘my profit & loss statement is not the same thing as my cash flow’.  Your profit & loss statement (a.k.a. income statement) may very well show that if you sell X many units of your product/service, you will cover your costs.  But will you be able to cover those costs at any given time?  This is where financial woes and bankruptcy lurks – the failure to keep a projected versus actuals cash flow spreadsheet can be your road to ruin.

What is your cash flow?  The movement of money into and out of your business (and don’t make the mistake of thinking your bank statement will suffice).  

Each week (or day in the case of some businesses) you have to pay certain expenses and the question your cash flow analysis can answer is this: will you be getting enough revenue into your bank to cover these costs?  Can you pay your bills, cover your loan payments, payroll, line of credit, et cetera?

Case Study:

This seems a real no-brainer….but…we had a client who wanted to expand his business with a rather large capital expense that he would have to pay off monthly (i.e. he needed a big loan to buy this big thing).  If you looked at his P&L statements, both historical and pro forma (projected), it all looked good on paper.  Probable revenues, minus cost of good sold (COGS), minus fixed costs equaled profit.  Hooray! 

Not so fast, sugar.  When we crafted a cash flow analysis and looked at how and when he actually collected payment from his two main types of customers, things did not look so rosy.  Given the seasonality and length of time it usually took to collect on receivables (when his clients actually gave him money), there were several months of the year where he could exceed his available credit.  In other words….bankruptcy…or, hopefully a really understanding bank manager…but let’s be real here….bankruptcy.

By analyzing his project cash flow and the impact this potential new big loan payment would have, our client was able to make better decisions. Namely, he recognized a large risk in his business model and realized he had to be strategic in the balance of his client types (in his case, those who pay in advance versus those who pay on completion).  Our client also realized he had to be more creative in how he financed this new purchase and he realized he had to renegotiate the terms of his line of credit.

You need to be able to make decisions based on the projected and actual state of affairs with your financial picture at any given time.  Your cash flow analysis is your tool for this.  It helps you know if your receivables are coming in fast enough, or if the increases in your Cost of Goods Sold have squeezed your margins too much, or if you need to increase your prices, or if you can actually afford to pay a certain expense at a given moment. Can you pay that big bill on the horizon? Are you collecting your receivables in a timely manner? Your cash flow analysis will answer these questions.

In Part II of this series we discuss how to avoid the second Pitfall:  Weak Business Management

In Part III of this series we discuss how to avoid the third Pitfall:  Weak Marketing Management

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Sources:

*Key Small Business Statistics – January 2009, Industry Canada

*Failing Concerns: Business Bankruptcy in Canada, 1997 Statistics Canada