Many small business owners make financial decisions based on how much cash they have in the bank.Â Unfortunately, there are a number of pitfalls to managing this way.Â Letâ€™s explore some ways that business owners manage by bank balance, the problems associated with these practices, and some alternatives that will help you stay in great financial shape.
1. You pay bills as they arrive, based on your bank balance.
When you receive a bill, do you check your bank balance to determine if you can cover it, and if so, pay it right away? There are two problems with this method:
- Youâ€™re not accounting for checks youâ€™ve issued but which have not cleared. The obvious risk here is that an outstanding check will clear, resulting in costly bad check and overdraft fees, as well as damaged vendor relations.
- Youâ€™re not planning for other obligations that could impact your payment decisions. You might pay some bills well before theyâ€™re due and unnecessarily deplete cash you later need.
Instead, implement and use a cash flow forecast and track accounts payable.Â A cash flow forecast starts with your reconciled account balance and predicts your incoming and outgoing cash.Â It tracks when you expect your revenue to come in and your bills and payroll to go out.Â Youâ€™ll have a complete picture of what bills are coming, when they will be due, and how much youâ€™ll have left over after theyâ€™re paid. You can predict cash shortfalls and adjust your payment schedules accordingly.
2. You send invoices out and wait for the money to arrive.
Failing to follow up on your outstanding receivables in a timely manner has a negative impact on your cash flow and skews your financial forecast.
Instead, use your accounting system to track accounts receivable, implement a collection policy, and follow up on overdue invoices. Youâ€™ll increase your cash flow by getting paid sooner. If you find out when a customer with a past due invoice will actually issue payment, you can update your cash flow forecast so that it remains accurate.
3. You make decisions on big purchases or new hires based on whether you â€œfeelâ€ like you can afford it.
When youâ€™re managing by your bank balance, itâ€™s difficult to know what you can or cannot afford. Are you currently cash-rich because of a windfall, or can you reasonably expect to maintain that income level?
Instead, review your historical income statement and balance sheet to see if youâ€™ve been consistently making enough money to cover the new obligation.Â Next, create an income statement budget, using past data to predict your future income and expenses.Â If you are still profitable after adding the items you want to purchase to the budget, create a long-term cash flow forecast.Â Does the cash balance stay positive?Â If youâ€™re profitable, cash flow positive, and your debt to equity and other performance ratios remain healthy, you can afford the purchase.
4. You assume projects are profitable because you have cash in the bank.
Cash in the bank doesnâ€™t mean that all of your projects are profitable. Some jobs may be profitable while others are not, or you may have debt that obscures your financial picture.Â The real question is: could you have MORE cash in the bank?
Instead, track all of your time and expenses against jobs in your accounting system.Â If a job is unprofitable, find out why. If you track this information throughout the project, you can make corrections to stay on budget where possible.Â You can also use that information to more accurately bid new jobs.
These relatively simple accounting practices provide a great foundation for making smart decisions that keep you on the right financial track.