The 3 Biggest Financial Errors Small Businesses Make
What makes so many small businesses falter and fail? What accounts for the high failure rate—50 percent in the first five years?[1] Blind spots and personality defects sometimes trip up small business owners and cause them to bring down the companies they have worked hard to build. Thinking you know all the answers is one such weakness. Trusting blindly: going with your heart, not your head, can also be a big blunder. Having either of these two tendencies can undermine an owner’s financial decisions. But you can also be without those defects and still commit big financial goofs that can doom a young company. Here are three correctable money and finance missteps that small business owners often make:
1 – Being undercapitalized. This is cited by the Small Business Administration as the second most-common cause of failure for young businesses.[2] Having investors or a line of credit at the outset and during the first years of growth significantly relieves the owner’s agita. It gives the company a small cushion when the economy hits a rough spot, accounts payable collections, or retail transactions slow and you need cash to pay the employees, buy goods, or keep the machinery running. Without that cushion, even one bad quarter can doom a company.
But failure isn’t the only potential negative outcome. An Inc. article points out that undercapitalization can “increase the likelihood of the owners of a corporation being held personally liable for business-related matters” if there should be a court order or a business debt.[3] If the owner(s) did not provide sufficient capitalization to begin with, such as if they put up a meager $500 to start a new business that realistically required $10,0000, “a court would be likely to rule that the extreme undercapitalization of the corporation made the owner personally liable for its debts.”
If you seek a loan as a solution, you’ll need a business plan. Creating one makes you think through and explain your strategy and management as well as pinning down numbers on cash flow and resources (i.e. collateral).[4] Other options, particularly if you’re looking for a small amount (less than $2 million, writes David H. Fater in his book, Essentials of Corporate and Capital Formation) is to find angel investors. The Angel Capital Association is one place to start, or check with local entrepreneurs, your Chamber of Commerce or your banker.[5]
2 – Not studying the balance sheet. A balance sheet is, to people who buy and sell stocks or companies, a window on a given business’ financial health. To a small business owner, his company’s balance sheet is a signpost showing progress, but it can also provide warning signs. Small business advisors recommend learning not just to read the balance sheet but learning to do certain calculations and analyses based on the figures on the sheet.
- For example, take the Total Current Assets and subtract Total Current Liabilities to find out how much Working Capital you have.
- Take Total Current Assets and divide by Total Current Liabilities to get Current Ratio. This tells you if you have enough money and other easily convertible assets to pay all your liabilities (other than debts that come due more than a year out). A good number for this should be 2:1 (twice the assets to liabilities), though it varies by industry. What can you learn from this analysis? “[A] very high current ratio might mean that cash on hand isn’t being used efficiently. For example, it might be a good time to invest in updated equipment for greater productivity.”[6]
- Conduct a vertical Common-size Analysis using the Total Assets figure and expressing each of the following as a percentage of that figure: Assets, Liabilities and Equity. “You want to look at these percentages over a period of about three years to spot changes,” advises a financial analyst in an Inc. article.[7] If you see that inventory is growing faster than total assets, you can proactively make changes rather than reacting to a situation that seemingly arises out of nowhere.
[1] SBA FAQ’s [2] What are the major reasons for small business failure? [3] Undercapitalization [4] Small Business Loans [5] North America's Professional Alliance of Angel Groups and Private Investors [6] Reading a Balance Sheet [7] How to Read a Balance Sheet [8] Conducting a Break-Even Analysis
