Inaccurate cash flow and expense forecasting is a leading cause of business failure and, ultimately, business closure. According to the U.S. Bureau of Labor Statistics, about one in five businesses in the U.S. fail within the first year. Half of companies fail within five years; two-thirds fail within 10 years. Only 25 percent of companies make it beyond 10 years.

Making it even tougher on business owners, of the 33.3 million small businesses in the U.S., only 35 percent are profitable, according to Guidant Financial. Only 9 percent of the 33.3 million have annual gross sales over $1 million, according to Small Biz Genius. According to Fundera, 86 percent of owners take a yearly salary of less than $100,000. Many of that last cohort work more hours per week than the typical W2 employee.

Entrepreneurs, driven by their inherent optimism and willingness to take risks, inspire us with their resilience in the face of the poor odds of success.

Despite the bleak data, the U.S. Chamber of Commerce reports that 73 percent of small businesses expect growth over the next 12 months. America thrives, in part, because of optimistic risk-takers. However, due to the high number of business failures and challenged profit margins, there comes a time when some level of defense should be mixed in with potential offense.

Business growth is important and satisfying, but so is protecting what you have. Forecasting your company’s cash flow can inform you if your company is ready to do both simultaneously. That is a challenging feat under any circumstances, much less while pursuing additional projects.

Cash flow analysis is the financial equivalent of a weather forecast, helping you prepare for both sunny days and potential storms.

A CASE STUDY IN CASH FLOW ANALYSIS

In 2018, Harvey’s electrical company in Hatfield produced $3 million in annual sales. Two employees trained in plumbing and HVAC were on his team; their work represented about one-tenth of the company’s sales. He wanted to expand those smaller divisions but was concerned that the capital required would threaten his thriving electrical business.

Harvey felt confident that he understood the cash flow of his plumbing business, which accounted for 90 percent of all sales. After all, the sales projection is at the heart of any cash flow forecast. This is arguably the most critical variable in your financial crystal ball. But how do you make these estimates accurate when expanding your business?

First, consider your market share. Are you a big fish in a small pond, or vice versa? Understanding your position in the market can help you gauge potential growth or anticipate increased competition.

Many of Harvey’s electrical customers were new and expanding commercial projects, which also required contractors for plumbing, heating, ventilation, and air conditioning (HVAC). Not only did the buildouts require multiple subcontractors, but the general contractor also needed to coordinate those groups. By including those additional services, Harvey was able to take sales from the competition by coordinating internally to shave weeks off a project.

Harvey also had to consider pricing in his cash flow forecast. Higher prices don’t always translate to higher revenue, and lower prices aren’t always the factor that drives deeper market share penetration. Harvey was torn because he knew his differentiator (a faster completion time with less friction) had value and should command a higher price. Still, the high-class problem of getting more business could be challenging with only two dedicated employees.

Once you’ve projected your sales, it’s time to factor in your costs. This step helps you move from revenue projections to profit estimates, giving you a clearer picture of your financial health. Start by calculating your projected gross profit. Gross profit is your estimated revenue minus the direct costs of producing your goods or services. Then, subtract your operating expenses to arrive at your net profit projection, a proxy for cash flow.

Harvey knew that he had to hire at least two additional employees before getting serious about bidding for new jobs, which would reduce weekly cash flow through payroll. Harvey then had to decide if he should use cash-on-hand for other needs. Harvey could get a discount on the cash purchase of reusable equipment (excavators, diagnostics, jetting machines, a new van) and inventory (air conditioner coils, heat pumps), potentially making the expansion more profitable in the long run. Alternatively, Harvey could lease the equipment, which would be more costly. He could also order inventory on demand, but that would delay completion, weakening his sales differentiation.

Growing and protecting your business isn’t just about making sales — it’s about making sales that generate positive cash flow. Harvey opted not to buy the equipment until the new sales built up a larger pool of capital reserves to access in case the business had to weather a potential storm.

Harvey decided to track the plumbing and HVAC sales for at least 18 months before committing capital reserves to purchase equipment and hold inventory. While it might be tempting to create monthly forecasts, this approach can lead to inaccurate predictions for many businesses. Factors like payment delays and billing cycles often extend beyond the short term.

While some business expenses remain relatively stable month to month, others can fluctuate wildly. Utility costs, for example, might spike during extreme weather conditions. Raw material prices could change due to supply chain issues or global economic factors.

To account for these variations, build flexibility in your cost calculations. This involves creating best-case, worst-case, and most-likely scenarios for your variable expenses. By doing so, you’ll be better prepared for a range of possible outcomes.

Don’t be discouraged if your forecasts don’t always match reality perfectly. Instead, use these comparisons as learning opportunities to refine and improve your forecasting process over time. Accurate cash flow forecasting is more than a one-and-done activity, whether you are expanding or just trying to maintain the status quo. It requires consistent effort and regular updates as new information becomes available.

Entrepreneurs are optimistic. But when it comes to financial forecasting, unrealistic expectations can be dangerous. That’s why regularly comparing your forecasts with your current cash flow statements is crucial. This practice serves two essential purposes.

First, it helps you identify any discrepancies between your predictions and reality so that you can adjust the tactics in your strategic plan. Second, it can reveal variables you have overlooked in your forecasting model.

For example, Harvey had to contend with the higher costs of sign-on bonuses when finding experienced employees in a tight labor market. Additionally, increased tariffs on snaking and jetting equipment increased costs substantially. The sign-on bonuses reduced his available cash, and the tariff costs made it more challenging for him to move from leasing to buying.

Since expanding his service lines, Harvey’s sales have doubled to $6 million. Part of that growth came from plumbing and HVAC revenue, but much of those sales were closed because he strategically aligned those two services plus electrical work. This differentiator made Harvey more attractive to the general contractors who sought his work because they could reliably bid shorter project times and reduce the logistics headache.

Harvey was able to grow his company safely by recognizing that cash flow forecasts are a valuable asset.

 

This article first appeared in the Berkshire Eagle on September 13, 2024.