When running a business, the future can be as clear as mud!
Updated: May 20, 2020
One of my clients purchased some farm land this spring and will drill a well on the property later this year to supplement the water situation. Pretty simple transaction, right!? That is until you want to represent it on paper for your lender or investor to show what will be happening from a numbers point of view. Cash is spent, assets go up for land and loan fees, partial interest is paid, accrued interest occurs, principal payments are made, depreciation and amortization happens. Not particularly easy to properly show on paper.
Now add the actual operation of the farm on top of this and you get things like regular income and expenses creating accounts payable, harvested crop inventory, investment in next year's crops, accounts receivable in addition to capital expenditures and draws for living expenses. How much cash or line of credit will my client need because he will be investing in the next crop before his current crop is harvested?
Cash flow and net income are very different here. Which do you follow? Both of course! The business can live off of the cash flow in the short term, but net income will ultimately drive the outcome.
Now this is what financial statements are all about and properly prepared accrual financial statements do a great job sorting this out after it is all said and done, looking backward though.
The problem is looking forward, however. In my consulting practice for over 30 years in dealing with private companies, I rarely find forward looking projections that start with a beginning balance sheet and follow through the projections to an ending balance sheet with the accrual entries for accounts payable, accounts receivable, inventory and accrued interest that properly reflect accrual annual net income and tie out to an annual cash flow on a forward looking basis. Without this though, it's like flying an airplane and not knowing where you are going until you run out of gas and then you land, sometimes unpleasantly. Cash is the gas, accrual net income is the route providing refueling stops along the way and the ending accrual balance sheet is your destination.
According to the Small Business Administration, about half of all establishments survive five years or longer (1). Turning this around, this means that about half fail within the 1st five years of start up and running out of cash might be an obvious cause.
Now none of this is rocket science or new to any degree, but what happens is that a simple transaction or business can become very complex which takes a tremendous amount of time and expertise to properly represent in a plan or projection. The result of this is that it just doesn't get done. It's not that easy, so only a rare few really take the time. I have been there and understand the pressures. Most of us do operate with budgeted performance measurements, however having those all tie out to a forward looking balance sheet is the key that represents what the destination looks like, good or bad.
We all fall victim to things like increasing sales by tightening the margins, feeling that volume will make up the cash, but do we fully incorporate the demand on cash for inventory or accounts receivable