Did you know that sometimes businesses spend more money than they earn? Although they are operating and making transactions, there is less money coming in than flowing out of the business. In such a case, the company's cash flow is in the negative and they experience cash flow problems.
What is meant by cash flow problems?
Problems with cash flow are very common among businesses.
Cash flow refers to the movement of money. The term describes money that comes into the business and the money that leaves the business.
Cash flow problems occur when the net cash flow in a business is negative. This means that there is more cash outflow than inflow, i.e. more money leaving than coming into the business). This occurs when a business spends more money than it receives.
Table 1 below presents an abstract of the cash flow statement of Company A in 2020.
| Total cash inflow | £120,000 |
| Total cash outflow | £50,000 |
| Net cash flow | £70,000 |
| Opening balance | £0 |
| Closing balance | £70,000 |
Table 1 - An abstract of a cash flow statement for Company A in 2020
As you can see, in 2020 the net cash flow and closing balance of company A were £70,000. This means that the cash flow was positive and the business did not experience any problems with cash flow.
Now, let’s have a look at table 2, which presents an abstract of a cash flow statement for company A in 2021.
| Total cash inflow | £80,000 |
| Total cash outflow | £160,000 |
| Net cash flow | (£80,000) |
| Opening balance | £70,000 |
| Closing balance | (£10,000) |
Table 2 - An abstract of a cash flow statement for Company A in 2021
Negative values are marked with parentheses in the cash flow statement.
In 2021, the cash flow of Company A was unfortunately negative, equalling -£10,000. The company experienced cash flow problems and should therefore think about the causes for this, as well as possible solutions.
Effects of cash flow problems
Cash flow problems should be taken seriously and never neglected, as positive cash flow allows businesses to retain cash and spend when needed or wanted. If cash flow is negative, a business should refrain from spending.
Some common effects of cash flow problems are:
Late or unpaid debts. Businesses that struggle with cash flow might be unable to pay their debts as they become due.
Inability to pay suppliers. Negative cash flow might make it impossible for a company to pay for raw materials sourced from suppliers.
Inability to pay staff wages. Firms that do not have enough cash inflows may be unable to pay their employees.
Inability to buy inventory. Lack of cash may prevent companies from buying inventory and as a result, stop their operations.
Causes of cash flow problems
Firms can experience cash flow problems for a number of reasons. These may include:
Cash Flow Problems: Poor management
Although it seems to be something that can be avoided, cash flow problems in many businesses are simply caused by poor management. This is because sometimes managers are simply unaware of the importance of cash flow management and thus do not plan it carefully.
Poor cash flow management can occur with both small and large businesses. However, it is more likely to happen in smaller firms that tend not to employ financial managers. Bigger companies also tend to neglect cash flow management when making financial decisions, as sometimes managers do not think about the influence they might have on a business’s cash flow position.
Company B has a chain of car washes across the UK. Recently, customers have been complaining about the poor quality of wipes making trails on the car window. For this reason, managers decided to change wipes suppliers. Without any research, they made a contract with a supplier offering more expensive wipes of the best quality on the market.
Unfortunately, although customers were satisfied with the quality of wipes, their high price resulted in higher costs for the company. After several months, the costs turned out to be so high that they outweighed the revenues of the company. Because of the quick and misguided decision, Company B experienced problems with cash flow.
Cash Flow Problems: Making a loss
Sometimes businesses experience hard times and do not make any profit at all. They make a loss, which is when over a period of time costs of production are greater than revenues.
Although making a loss does not necessarily have to mean that a business’s cash flow is negative, it typically leads to running out of cash. The business is still spending money to operate, but it isn't earning enough money to cover its expenses.
Company C produces and sells cow's milk. Recently, more and more people have gone vegan and the demand for cow's milk has decreased. Even though people do not buy as much cow's milk as they used to, the company still has cows that have to be fed and taken care of.
Although costs remained the same, the reduced demand lowered revenues, making revenues lower than costs. Thus Company C stopped making profits and started making losses, which resulted in problems with cash flow.
Cash Flow Problems: Allowing customers to take too long to pay
Many companies allow customers to buy products on credit or in instalments. In doing so, they allow them to pay later and deny themselves inflows of cash.
Customers may often wait a week, month, year, or even longer to pay. If the time customers take to pay is too long, a business is likely to experience cash flow problems. In spite of making transactions and spending money on the production of certain goods or services, the business does not receive any money.
Company D is a newly established travel agency that allows customers to book a holiday and pay after up to a year. The company was making transactions and sending customers on holidays, but as a start-up, it did not receive any money in the first year of its operation.
This meant that in the first year of operating, Company D did not have any cash inflow. However, it had a lot of cash outflow, as it was regularly carrying costs related to transport, accommodation, etc. As a result, the net cash flow of Company D was negative in the first year of operation and at the beginning of the second year, the company experienced cash flow problems.
Methods of solving cash flow problems
Depending on the causes of cash flow problems and the business circumstances, managers can find the right solution to the problems faced by the business.
Some of the solutions that businesses can implement to resolve cash flow problems include (see Figure 2 below):
Rescheduling payments. When experiencing cash flow problems, a business can try rescheduling payments. In doing so, it can try talking to its suppliers or other parties to whom it owes money and ask to postpone payments.
Using overdrafts. An overdraft is a short-term flexible loan a business can use whenever it needs. It is a quick and easy way of gaining money that provides an immediate inflow of cash.
Cutting costs. When faced with cash flow problems, a firm can try to cut its costs to reduce the outflow of cash. It can, for example, try to find alternatives by using cheaper sources of raw materials or fuel.
Finding new sources of cash inflows. Some businesses might be able to come up with initiatives that will allow them to earn more money and generate extra inflows of cash.
Cash flow forecast
Forecasting cash flow can help a business understand its cash flow and prepare for potential problems in regard to this.
Cash flow forecast refers to the estimates of a company's future cash flow.
As a cash flow forecast allows a business to estimate its future cash flow, it might be able to predict future cash flow problems as well. Having estimated how much money will flow in and how much will flow out of the business, managers can determine whether the cash flow will be positive or negative and why. If the cash flow is expected to be negative, they will be able to take action to prevent possible cash flow problems in the future.
Although cash flow problems are a common issue for many businesses, they should never be neglected. Managers should always analyse the causes of cash flow problems and find solutions to avoid their effects.
Cash-flow problems - Key takeaways
- Many businesses experience problems with cash flow.
- Cash flow problems are when the net cash flow in a business is negative.
- The effects of cash flow problems may include late or unpaid debts, an inability to pay suppliers or staff wages, and an inability to buy inventory.
- Some common causes of cash flow problems are poor management, making a loss, and offering customers too long of a term to pay.
- The methods of solving cash flow problems include rescheduling payments, using an overdraft, cutting costs, and finding new sources of cash inflows.
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