Wednesday, December 1, 2010

Undercapitalization, a potential death blow to your business

Undercapitalization is without a doubt the number one reason businesses fail.

If you’re starting a business, you need to carefully make projections on anticipated revenues and anticipated expenses. And, if you’re like the vast majority of entrepreneurs you will overestimate revenues and underestimate expenses. Therefore, after having been brutally honest (and I do mean brutally) with your projections, you need to double the amount of capital your projections show you’ll need. I’ve never known a businessperson that was sorry he had too much cash on the balance sheet. However, I’ve spoken with numerous business people who rued the day when they ran short of money. And remember, approximately 30% of all businesses that go broke had income statements that showed they were making money! That’s right the books may have shown they were “profitable”, but profit doesn’t mean positive cash flow. Money tied up in inventory or accounts receivable can’t be used to make next week’s payroll.

Now if you’re presently in business and making a decent profit, congratulations. But, before you start patting yourself on the back, remember the old saying “those whom the gods will destroy, first make overconfident”. Overconfidence can seduce you into being overextended. You may take on too much debt because business is good and you’re convinced you can cut a fat hog by wildly expanding. Then, guess what happens? The economy goes south and you find yourself over-leveraged and in trouble. Most savvy bankers won’t let your debt to equity go beyond 2 ½ to 1 or at the very most 3 to 1. The sad facts in today’s lending environment are you’re lucky if your bank will loan you any money regardless of whether or not you’re profitable. Now, if you are one of the lucky businesses that can get a bank loan, don’t let your debt to equity exceed 2 to 1. It has always been true…..CASH IN BUSINESS IS KING! So, be conservative, you won’t be sorry.

Next Week’s Blog: Resign Accounts?

No comments:

Post a Comment