Cash Flow Problems include primarily three things – poor Cash Inflows, increasing Cash Outflows and having negative Closing Balance.
All businesses must have healthy Cash Flow in order to generate sufficient Working Capital to pay their workers, managers, suppliers, lenders, landlords, the government, etc.
The main causes of typical Cash Flow problems
Here are the following three most common problems with Cash in a typical business organization, along with the main reasons causing each of those Cash Flow problems.
PROBLEM 1: Poor Cash Inflows
- Inadequately high prices. With prices being too high than what customers are able and willing to pay, it will prevent the business from converting stocks (ready goods) into cash. When pricing policy is wrong, it will not help anyhow to offload excess stocks. For example, prices may be too high for products that have lots of substitutes or for those goods that are at the end of their Product Life Cycle.
- Poor Product Portfolio. Businesses selling only one product, or with very limited and narrow Product Portfolios, are less likely to generate increased Sales Revenue. Poor sales in one product cannot be offset by better sales of other products. However, broadening Product Portfolio is not always the ultimate solution as it may cause further Cash Flow problems. Introducing new products to the market may raise costs and risks yet does not guarantee higher Cash Inflows.
- Loss of a major customer. Losing an important customer, or even more main customers, will be a serious problem for a business as it will suddenly lose a big proportion of its Sales Revenue. Those customers leaving the business can result from the firm having many unpopular products in the firm’s portfolio without innovating new products, or suddenly stopping the production of popular products. Another reason can be a direct competitor lowering prices unexpectedly, or a new competitor with innovative technology entering the market. Any increase in market competition could lead to reduced demand, hence poor Cash Inflows.
- Too long Trade Credit. In many trading situations, businesses will have to offer trade credit to customers in order to be competitive. Simply, because other companies do so. If a customer has a choice between two suppliers selling very similar products, if one insists on cash payment ‘on delivery’ and the other allows two months’ trade credit, then customers will go for credit terms because it improves their Cash Flow. However, when the company is allowing its customers too long to pay debts, it means reducing its own short-term Cash Inflows which could ultimately lead to Cash Flow problems.
- Lousy credit control. Credit control means monitoring of debts to ensure that trade credit periods are not exceeded. The credit control department of a business keeps a check on all customers’ accounts: those who have already paid, those who are keeping to agreed credit terms and those customers who are not paying on time. If this credit control system is badly managed, then Debtors will not be ‘chased after’ for payment and potential bad debts will not be effectively identified. Cash Flow problems can arise when a firm offers customers an extended trade credit period, leading the business to trade for long periods without any Cash Inflows. It can also arise if too many unreliable customers are offered trade credit as it increases the chances of bad debts being experienced.
Bad debts are caused by unpaid customers’ bills (debtors who fail to pay not only on time but at all) that are now very unlikely to ever be paid.
PROBLEM 2: Increasing Cash Outflows
- Overstocking. Overstocking happens when the business buys and holds too much inventory than it is needed to fulfill normal demand as it freezes its cash unproductively. Excess stock levels represent a waste of scarce resource – C-A-S-H which could have been better spent elsewhere. Holding too much stock, which is the result of an ineffective stock control system, will require heavy cash spending, hence Cash Outflows will increase. It is because raw materials cost money to buy from suppliers, work in progress requires money to be produced and ready goods cost money to be stored somewhere safely.
- Overtrading. Overtrading occurs when a business attempts to expand too rapidly without having the sufficient resources to do so – land, labor, capital and enterprise. When it accepts the excess orders than what it has the capacity to handle at the moment, the need for increased production will require the firm to add production costs. When a business expands rapidly, it has to pay for the expansion (e.g. increased wages, more raw materials, etc.) many months before it can receive cash from additional sales. The purchase of Fixed Assets as a part of rapid expansion also consumes cash, thus reduces Working Capital of the business. Without any corresponding revenue, which only comes after the product has been manufactured and sold to customers, overexpansion can lead to serious Cash Flow shortages. So, even though the business expansion is successful, without obtaining all of the necessary finance to cover Working Capital requirements in the meanwhile, Cash Flow shortages are likely to develop.
- Rapid price increases. Cumulative Cash Outflows will increase substantially when prices in the economy increase more than expected, hence budgeted by the Finance Manager. These unforeseen increases in costs can happen as a result of price increases of raw materials, higher rent, higher energy costs, etc. due to major supply shortages. Limited supply of products can often be caused by military conflicts, wars, supply chain disturbances, health epidemics, etc.
- Overborrowing. The business usually borrows money to pay for day-to-day expenses in the short-term and to pay for business expansion in the long-term. When a larger proportion of capital is raised through External Sources of Finance, the higher the Cash Outflows there will be on interest payments. When interest rates in a country increase, any Cash Outflow on loan interest will also increase. This will put additional pressure on the business’s Working Capital, hence may negatively influence the liquidity position.
PROBLEM 3: Having negative Closing Balance
- Lack of planning. Appropriate forecasting of Cash Flows can greatly help in predicting any potential future cash problems for a business. So that business managers can have more time to act upon to overcome them in time.
- Serious miscalculations by management. While Cash Flow Forecasts can never be guaranteed to be 100% accurate, not forecasting Cash Flows at all can bring immense consequences on the whole business. Serious misjudgments about Cash Flows by the management team can cause negative Closing Balance for too long, hence threaten potential liquidation of the business.
- Unforeseen changes. Many unexpected events can happen any time during the month leading to negative monthly Net Cash Flows. This can seriously affect the smooth running of a business. Some of the unforeseen changes may include machinery breakdowns, random fluctuations in demand, a breakdown of delivery vehicles, natural disasters damaging Fixed Assets, any serious health crisis that stops production workers from coming to work, etc.
In short, while neither Cash Flow Statement nor Cash Flow Forecasts do not solve Cash Flow problems by itself, it is an essential part of financial planning in the hopes of fixing Cash Flow problems. And, of course to help prevent Cash Flow problems from developing further in the future.
