Why can a profitable business run out of cash? (7 reasons cash runs dry)
How can a company have a profit but not have cash?
It may seem crazy that you can have a profitable business and yet it has no cash. It is important to understand that profit doesn’t equal cash. This is especially true of businesses that offer payment terms to customers. Profits need to be turned into cash, otherwise cash will run out. But why can a profitable business run out of cash? Let’s take a look…
Why can a profitable business run out of cash in 20 seconds…
Just because a company is profitable doesn’t necessarily mean it has cash. Profits need to be converted into cash. Companies need to make sure customer receivables are converted to cash. Stock must be managed and kept to a minimum. Also, close attention needs to be made to any differential between customer receivable credit terms vs major supplier payable credit terms. It’s more likely that a rapidly growing businesses vs a slow growing business will run out of cash, which is termed overtrading. Cash flow and working capital requirements increase as business growth rates increase. This is reflected in having to increase stock or inventory levels and having to hire new people.
Why can a profitable business run out of cash?
It’s more common than you might think that companies are profitable, but run out of cash. It makes sense that a loss-making business would run out of cash, but why can a profitable business run out of cash?
Reasons why a profitable business run out of cash:
- Growing too fast too quickly or over-trading will cause profitable businesses to run out of cash.
- Not assessing working capital or cash requirements at the outset.
- Customer receivable credit terms are more lenient than major supplier payable credit terms will drain cash.
- Failing to collect customer receivables will stop profits being converted to cash.
- Holding too much stock or inventory will tie up working capital.
- Major capital expenditure wipes out the cash of many profitable businesses.
- Significant bad debt will result in a profitable business running out of cash.
Let’s now take a look at the reasons why a profitable business run out of cash in more detail.
1. Growing too fast too quickly or over-trading will cause profitable businesses to run out of cash
Overtrading usually arises as a result of not having enough working capital in a business. Or put another way, the business simply runs out of cash. The phrase or saying “cash is king” is one of the fundamentals of any healthy business.
Overtrading often occurs when companies expand operations too quickly or aggressively. If you are chasing sales, whilst not chasing the money at the same time, you could wind up running out of cash and going broke.
Overtrading or running out of working capital is more likely to happen if your business has significant cost of sales. This is even further exacerbated when credit terms to customers are more lenient vs the credit terms you have with your major suppliers (see point 3 below).
It’s more likely that rapidly growing businesses vs a slow growing businesses will run out of cash. It is this which is termed overtrading. Cash flow and working capital requirements increase as business growth rates increase. This is reflected in having to increase stock or inventory levels and having to hire new people.
2. Not assessing working capital or cash requirements at the outset
This reason follows on directly from the previous point. Overtrading and the problems this will cause a business can be avoided through better planning and forecasting.
Before you embark on a rapid business growth plan, you should prepare cash flow forecasts beforehand. This will allow you to assess the business working capital requirements before you accelerate growth.
With good cash flow forecasting software you should be able to model your business growth plans. Cash forecasts will help you to understand how much working capital you will need for your planned growth.
You can then plan accordingly using the right level of marketing to set the growth based on the working capital you have access to. But at the same time knowing that you modelled the receivable credit terms vs the payable credit terms. You understand how much cash will be required for the stock levels estimated for the growth plans.
You’ll also be able to plan and forecast staffing levels and costs associated with the planned speed of growth.
3. Customer receivable credit terms are more lenient than major supplier payable credit terms will drain cash
Too many businesses run out of cash purely and simply because they let their customers have better credit terms vs the credit terms they receive from major suppliers.
As an example, let’s say your business offers 60-day payment terms to your customers. But on the other-hand, your major suppliers offer 30-day payment terms. Or worse still, your supplier payment terms are to pay before delivery or cash on delivery.
In a situation where sales are increasing significantly month-on-month to the extent that the timing when cash is received vs the timing when money is paid out reaches a point where cash simply runs out.
This is more likely to be the case in a business where the gross profit margins are tight. If purchases form a high percentage of sales, such that the business needs to have a high turnover to generate a net profit, this is when cash may run out. This is especially the case when the suppliers need to be paid faster than cash is being generated from customers.
If you don’t have enough working capital (or cash in the bank), in these circumstances the business will fast run out of cash, even when it’s making a profit. Unless extra funding is sought to cover the cash flow short-fall, the business will go broke. This would be despite making a profit. In this case the cash flows are not keeping up with the profits being made.
4. Failing to collect customer receivables will stop profits being converted to cash
Many business owners make this mistake and fail to collect receivables in a timely manner. Often times business owners boast about the turnover of their business, but without necessarily focusing on what’s more important, i.e. profit. However, profit on its own is not enough for a health business, as profits must be converted into cash.
As already mentioned above, cash is king. It’s almost pointless invoicing customers if you fail to collect what they owe. If your business is making profits, but the profits aren’t being banked, you’ll soon run out of cash.
This is why it’s important to employ an external or an in-house credit controller or debt collector to enforce your payment terms. You should implement credit checking on your customers and routinely update this check.
To maintain a healthy cash balance it’s vital to enforce your credit terms. Keep your customers to within their credit limits and make sure they pay their invoices on time. Don’t be afraid to put a customer on stop where they breach either of these two parameters.
5. Holding too much stock or inventory will tie up working capital
Managing stock or inventory is never an easy job and is always high on the agenda for management. It’s always a difficult balance between holding enough stock so you avoid running out, but then not holding too much stock so your business is over-stocked.
If your stock or inventory levels are too low, you’ll end up not being able to fulfil customer orders in a timely way. This will annoy customers and will have a detrimental affect on your business.
However, on the other hand, if your stock or inventory levels are too high, this will mean you have too much cash tied up in stock. This will mean that too much of your working capital is tied up, but it could lead to stock become obsolete.
6. Major capital expenditure wipes out the cash of many profitable businesses
If your business is in need of significant capital expenditure, this can wipe out a significant cash balance. Perhaps you’ve decided to buy your own business premises, or you may need to upgrade your plant and machinery. Either way you need to plan these types of major expenditure.
A good way to do this is to prepare cash flow forecasts in order to work out cash requirements. But where cash is not sufficient to keep the operations going at the same time as investing in capital expenditure, then a bank loan might be required.
This is when a decently prepared cash flow forecast with and appropriate business plan will help in securing the loan.
7. Significant bad debt will result in a profitable business running out of cash
Any bad debt is painful. Having a customer go bad on you is difficult at the best of times. But having a significant bad debt occur can cause major problems.
What many business owners don’t realise until they have a significant bad debt is the double hit that happens. When you suffer a bad debt you not only lose the money that’s owed to you at the time the customer goes broke, but also you lose the ongoing sales to that customer too.
Depending on the timing of the bad debt and the level of money lost, this could significantly affect your working capital cash balance. If the timing of the bad debt coincides with a significant cash outlay (let’s say it’s time to pay your taxes), this can cause significant problems.
As already mentioned though, it’s not just the loss of immediate cash, it’s also the loss of future sales and cash from the lost customer than can hurt too. It is for this reason that you should never be beholden to any one customer. You should also try to avoid having a few customers that make up a significant percentage of your turnover.
If one of these major customers go out of business, this could not only wipe out your cash, but it could lead your business to go bust too.
I hope you enjoyed this article about why can a profitable business run out of cash
I hope this article has helped in someway to solving your question about why can a profitable business run out of cash. If you have any further questions, please pop them in the comments below.
But also, if you can relate to any of the elements in this article, please share your comments on this too in the comments section below.
Also, please share this post on your favourite social media platform, thank you.