Entrepreneurs, investors and accountants all love to see updated income forecasts. While their projections are usually rosy, more than half of these businesses will fail within the first four years of operation, according to a 2012 University of Tennessee study. Of those failed businesses, 72 percent say they went out of business because they ran out of cash, and 77 percent were started with the owner's money.
Worse, many of these businesses failed after hitting their forecasted spreadsheet projections. Why? These businesses only forecasted profits. In doing so, they've fooled themselves into believing that sales equal cash and payments and deposits equal income.
None of this is true. I can work, earn a profit and not get paid for up to 90 days. Equally true: I can make a sale, receive a pre-payment or deposit and all that I have done is create a liability for myself. I still have to go out and do the work, which is a liability, without future cash because I already got paid.
What if I used that client deposit to make payroll this month? I might be out of business next month.
Forecasting income based on proper accounting standards is important if you want your business model to run smoothly. That’s because an “accrual” income statement aligns revenues to their related expenses for each month. In doing so, companies can quickly see if they have efficient overhead, are pricing their products and services correctly and have a competitive gross profit margin, among other key financial metrics.
However, forecasting an accrual-based income statement won't tell you when your company will actually see cash from your revenue. Take a legal or accounting firm, for example. They will often perform the work and not see payment for 30 to 60 days, while employee salaries, benefit costs, rent and other expenses must be paid before collection. If your firm doesn't have available cash to cover these costs, you're in trouble.
The same issue may apply to product-based companies who outsource operations overseas. Say, for instance, a U.S. company orders a large shipment of t-shirts from a third-party supplier for their imprinting business. They typically pay a deposit to get their order fulfilled. On a standard accounting income statement, such a reduction in cash would not appear right away, but rather only be counted as an expense until the t-shirts were not only received, but sold.
This may not occur for several weeks or even months. However, payroll still has to be made and bills still need to get paid. So while a normal income statement shows that everything is rosy for the business, they may in fact run out of cash before they see a dime from the sale.
Cash is king which means you must pay close attention to when your business operations are putting real dollars in the bank. Very few small businesses bother to forecast such a cash flow statement, but without it, you are flying blind. That means you could be increasing sales and currently have cash in the bank while simultaneously running out of future cash.
Income statement forecasting provides vital data on how a company is operating. Entrepreneurs use this data to achieve real meaningful profits. Even if your business has strong sales and a great vision, you can force it into bankruptcy by not forecasting and maintaining adequate cash reserves.
The author is an Entrepreneur contributor. The opinions expressed are those of the writer.