Owning a business is part of the American dream, but starting or running a business is not easy. There are six critical small business financial mistakes a successful business needs to avoid.
Top 6 Small Business Financial Mistakes
Many new businesses start every year, and many fail. These top 6 small business financial mistakes can be avoided and are summarized below:
- Insufficient capital
- Not understanding profit
- Cash mismanagement
- Little to no planning
- Not having a proper set of books
- No Small Business Financial manager
1. Not Enough Capital
The main reason a business fails arises when the company does not have enough capital. The owner may have a great idea. However, if there isn’t enough money to start or survive, the business will not succeed if initial sales aren’t as expected.
The amount of capital necessary to keep a business going and to sustain it will, of course, vary based upon the type of business. For example, a service business run out of the home by a single person will require much less capital than a manufacturing company that needs a building, equipment, and employees to operate.
Determining the amount of capital needed and how it will be used requires careful planning (see mistake number four below). Once you determine the amount, then you need to find the capital.
Difference Sources of Capital
- Owner’s funds
- Money from family
- Loans
- Investors
The owner’s funds. This is the most likely and common source of capital. The prudent owner will have saved the amount necessary to begin the business.
However, many owners start the business without having planned to save what the business needs. If the owner doesn’t have the necessary capital, then the owner may have to find other sources.
Money from family. If the new business owner does not have the personal funds to start the business, family members may help. However, problems can arise if the family member is unaware of the risks involved or if they have expectations of being repaid and the business cannot do so in the time frame expected or at all.
Loans. The business owner can seek out loans from banks or other individuals to initially capitalize a business. The problem here is that banks are not likely to lend money to a new business unless the owner is willing to put up some of their own assets (such as their house as collateral).
On the other hand, if you obtain a loan, you’ll have to pay it back—with interest. If sales don’t cover the cost of the loan, the owner risks losing their business, and the assets pledged for the loan.
Investors. Many people invest in a new enterprise. The problem here is that they want an ownership share of the business and the profits. The business owner must determine how much they are willing to give away for the investment.
In almost all situations, they should not give up a majority of the ownership and control of the business.
2. Not Understanding Profit
No business will succeed if it doesn’t make a profit. But, unfortunately, many small business owners have no idea if they are profitable or not.
Common Profit Misconceptions
- Not enough sales
- Little to no profitable sales (gross profit)
- Lack of controlling expenses
- Little to no net profit
Not generating enough sales. This is self-explanatory.
Little to no gross profit. Gross profit is the difference between sales and the cost of generating sales (also known as direct costs). This varies depending upon the type of business.
A one-person service business may have little or no direct costs, but a larger company like a small manufacturing company or a retail store will have high direct costs.
In a manufacturing company, the direct costs would include materials, labor, and a portion of overhead related to the production process.
In a retail business, the direct costs would be the cost of the goods that are going to be sold.
Regardless, if these direct costs exceed the number of sales, there is a loss on every transaction and no amount of additional sales will correct that. Understanding this is one of the crucial components of business success.
Not controlling expenses. Expenses (as opposed to direct costs) are rent, utilities, and other services necessary to operate the business but directly affect sales. Expenditures on these items need monitoring and controlling. They are not, however, as important as the gross profit mentioned above. A business succeeds by maximizing its gross profit, not by saving on paper clips.
Not having enough net profit. However, after all the sales, direct costs, and expenses are tallied up, there should hopefully be enough profit left to compensate the owner or expand the business.
If there isn’t, the owner has to decide if the business is really an opportunity worth pursuing.
3. Not Managing Cash
Cash (or capital), as mentioned before, is crucial to the ongoing success of the business.
Two major components to cash management:
- Cash flow
- Reserves
Cash Flow. Many businesses are simple cash businesses. They receive money when they provide a service. This doesn’t present cash flow issues unless not enough sales are being made.
However, other businesses will perform the work and give their customers time to pay. A normal time frame is 30 days.
When the work is done, it is considered a sale from an accounting standpoint, but they have yet to receive the cash. This is also referred to as accounts receivable.
If the business owner operates this way, they can quickly run into a shortage of cash compared to the work (and the expense) that is already done. Proper cash flow management requires monitoring who owes the business money and how long they are taking to pay.
The owner must follow up and collect this money to maintain a healthy cash flow.
Cash Reserves. Very few businesses accumulate and maintain a substantial cash reserve. Reserves allow the company to plan for future needs and to evaluate new opportunities.
A large cash reserve allows the business to reduce debt, hire new employees, acquire more equipment, and, in general, grow the business. But, again, this goes back to making sure the business is properly capitalized.
4. Not Enough Planning
The business owner needs to do some planning. If you don’t know where you want to go, how will you get there?
Planning starts the minute the idea for an owner conceives the business idea. But, It is also an ongoing process. Almost all business owners will agree that they need a plan. Yet, few ever do it because they are too eager to get started or too busy “running” the business.
Some small business owners will hire a company or professional to create the plan for them. The result is usually a comprehensive, nice-looking document with the plan of the person who prepared it, not the business owner.
Others will see the wealth of books available and become overwhelmed.
Some Simple Planning Tips
- Define the purpose of the business
- Prepare a budget
- Planning direction and control
On a single piece of paper, define the purpose of the business. Then, describe what the business will do and its benefit to the customer and the business owner.
Prepare a budget. This is usually the most intimidating part of the process because it involves numbers and assumptions and most likely not what will really happen.
Suppose the business owner is not comfortable with numbers or spreadsheets. In that case, a professional such as a Certified Public Accountant (CPA) specializing in small business financial management can help handle the logistics.
A good professional will help the business owner set up a spreadsheet. Then, they will ask the right questions to help turn the owner’s visions and assumptions into numbers and a meaningful plan.
A good planning process will force the owner to identify what needs to happen to get the business started (stuff like equipment and insurance, for example). The budget will also help the owner determine the amount of capital needed (see mistake number 1 above).
Planning-Direction-Control. Big businesses do this; why shouldn’t small businesses? All this means is that the business owner establishes a plan (budget) and uses the plan to direct the business’s operations. Then, you monitor the plan monthly against what really happens to determine deviations from the plan you can analyze and either control or adapt to.
A good budget combined with a good accounting program and a small business financial manager will accomplish this.
5: Not having a proper set of books
The financial success of a business certainly involves the vision and expertise of the owner.
But, just as valuable, setting up a proper set of books will make certain numbers correct. An appropriate set of books will provide the owner with the information needed to avoid the mistakes mentioned above.
6: Not having a Small Business Financial Manager
Large companies have a whole department dedicated to avoiding these mistakes. The head of this department is commonly known as a Controller. Unfortunately, small businesses cannot usually afford to have a full-time professional to help with the company’s financial direction.
Avoid These Small Business Financial Mistakes with the Right Help
Professional small business financial managers, such as a CPA, can assist independently at a fraction of the cost of a Controller. In addition, expert business financial management can provide many, if not all, of the services necessary to avoid these financial mistakes.