Business man planning financial forecast

Why Businesses Fail Financially

“Running out of cash” is the most common cause for business failure. But cash shortfalls are actually a symptom of deeper, systemic problems rather than just a standalone issue. Throughout our years of providing CFO services we’ve seen three gross management errors cause the majority of business failures. Here are the causes, symptoms, and remedies to help you avoid the embarrassment of a failing business.

1. Overly-Optimistic Forecasting (or the Absence of Forecasting)

At the heart of the most common financial pitfalls is the unbridled optimism of an entrepreneur. This optimism, while crucial for taking risks and seizing opportunities, often clouds judgment, leading to expectations of big sales that remain forever on the horizon. In pursuit of the big sale, fundamental financial strategies go out the window, expenses and staffing levels remain unsustainably high, and cash dwindles.

Symptoms to Watch For:

  • Persistent reliance on ‘the big sale’ that’s always just out of reach.
  • Refusal to adjust staffing levels or cut expenses in response to delayed revenue.
  • A noticeable disconnect between projected and actual revenues.

Recommended Remedies:

  • Implement a professional, data-driven forecasting approach.
  • Collaborate with skeptical and conservative managers on financial risk mitigation.
  • Regularly review and adjust go-to-market strategies to reflect real-time feedback and market conditions.

2. Undercapitalization

Businesses are undercapitalized when their resources are insufficient to sustain operations, often due to excessive debt, a failure to account for business seasonality or cyclicality, or owners drawing too heavily from the business. The result is never enough cash to pay vendors, make payroll, or invest in equipment or systems required for basic operations.

Symptoms to Watch For:

  • Cash flow crises during off-peak seasons despite healthy sales at other times.
  • Increasing reliance on debt to fund day-to-day operations, especially credit cards, high-interest debt or MCA loans.
  • Owners frequently extract funds for personal use, undermining financial resilience.

Recommended Remedies:

  • Develop a comprehensive understanding of the business’s seasonal and cyclical financial needs through budgeting or forecasting.
  • Plan and execute staffing reductions during off-peak or slow seasons.
  • Implement strict controls on debt, purchasing, and owner withdrawals.
  • Build a reserve fund to cushion against seasonal dips and unexpected downturns.

3. Misunderstanding Gross Margins

Poor accounting practices, particularly the misclassification of variable costs as operating expenses, can paint a misleading picture of a product’s profitability. This misunderstanding leads management to erroneously believe they have high gross margins, push for more sales volume, and believe one day it will cover overhead expenses. In reality, they are digging their way deeper into a hole by incurring losses on each additional unit sold.

Symptoms to Watch For:

  • Constantly increasing sales without an increase in profitability
  • Telltale signs of costing errors, such as:
    • Inconsistent, sometimes negative gross margins
    • No labor in cost of goods sold
    • No inventory on the balance sheet (for product companies)
    • Cash basis accounting.
  • A sales team solely focused on one product that is easy to sell (and often the least profitable.)

Recommended Remedies:

  • Work with a professional cost accountant to identify misclassified costs.
  • Analyze gross margins for each product or service individually, rather than relying on an aggregated view.
  • Eliminate unprofitable products and services; or, invest in cost-savings initiatives before growing sales.

Navigating away from Failure

Running out of cash is always a symptom of deeper issues that require careful diagnosis and targeted treatment. Financial risk mitigation begins with recognizing the signs of impending business failure. Implementing the recommended remedies involves a blend of strategic foresight, disciplined financial management, and an unwavering commitment to realistic, data-driven decision-making. With these financial strategies, businesses can navigate the treacherous waters of financial management and steer towards a more sustainable and profitable future.

Curious how CFO services can help you avoid financial failure? Schedule a call to talk to our team.

This article was written by a CFOshare employee with assistance from generative AI for rhetoric, grammar, and editing. The ideas presented are a combination of the author’s expertise, original ideas, and industry best practices.

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