A friend of mine who runs an IT company seemed to be doing really well. He had a fancy office, a handful of wonderfully talented staff, and some big clients all over the world. However, one day he said, ‘He’d put his business up for sale, but there were no buyers.’ On further investigation, I realized that his business had cash flow problems. He had clients who were paying well, but he was spending more money than he was making.
After being in business and consulting for over 10 years, I’ve realized that a majority of entrepreneurs make these common financial mistakes.
1. Not knowing the difference between profit and cash flow
Accounting is the language of business, and it’s important to at least understand the basics. Most businesses use the accrual form of accounting where revenues and expenses are recorded when they are incurred, rather than when they are paid. It’s possible for a business to be profitable but still struggle to pay its bills.
If entrepreneurs put in a little bit of time and effort, they could master this skill.
2. High fixed costs
Fixed costs are expenses like office rent, salaries and mortgage payments that are incurred every single month irrespective of whether you get clients or not. Every fixed cost needs to be justified. Start-ups need to figure out if a fancy office in an expensive location makes sense. A lot of companies are hiring remote workers which cuts down travel time and office costs. During the early days, it’s always important to keep your fixed costs low.
It’s also important to measure the ROI of every single employee. A lean, efficient team is far better than a large, overrated team.
3. Not having a budget
One of the most important responsibilities for a CEO is capital allocation. Budgeting is an important skill. Projecting where money is going to be spent on a monthly basis can help entrepreneurs avoid stressful fire fighting issues.
The hardest part for entrepreneurs is to stay disciplined; they are usually trying a zillion things without finishing anything. Sometimes, there are expenditures that don’t fit your budget. During these times, it’s important to let go and focus only on things that are absolutely important.
Graeme Donnelly, CEO of Quality Formations says, “It’s also important for entrepreneurs to separate their personal finances from their business. Entrepreneurs should treat a business as a separate entity. This is one of the biggest challenges for a sole-proprietorship. We encourage our clients to incorporate early, the costs are not as high as they seem. Besides, the benefits far outweigh the costs.”
4. Overestimating revenues
Entrepreneurs are optimistic people, they usually tend to have very high expectations. Most revenue expectations are unrealistic. It’s important to keep these numbers realistic. Sometimes, revenues depend on external factors that are not under the entrepreneur’s control.
5. Underestimating costs
Most start-ups end up spending more than their budgeted expenses. Everything starts with a budget, it’s easy to get excited and make some big moves that don’t work out and end up costing the company a lot of money. It’s important to keep emotions in check. Don’t spend more money than you can afford to lose. Start small.
6. Not enough working capital
A lot of people are living pay check to pay check. Sometimes, it’s the same for start-ups that are bootstrapped. Start raising capital before you need the money. Ideally, start-ups should have at least 6 months expenses as working capital.
7. Using too much debt
Banks are willing to loan money to small businesses with a personal guarantee from the business owner. It’s easy to get tempted into debt. Debt might be cheaper than investor capital, but it involves the highest amount of risk. Loans need to be paid back even if the business fails. So entrepreneurs need to be prudent with debt.
Managing finances efficiently is one of the most important activities in any business. It may not be as exciting and dynamic as product development or marketing, but it needs to be done.