What causes cash flow problems?
The standard answer is timing. You are collecting your accounts receivable on different days from when you pay your vendors or employees. Whether this is truly the cause or not can be proven in several ways, the easiest of which is to check the trend on your balance sheet to see if your debts are growing faster than your equity.
The second possibility is that you have a hidden investment in growth. I call it hidden because it is not evident from looking at the financial statements. To facilitate growth, a business needs excess capacity to service new customers. Much of this excess capacity is not developed by buying new buildings and equipment. Rather, it is done by increasing the number of employees, improving training, and updating processes. This investment appears on the financial statements as an ever-increasing overhead. If the new sales happen, then the overhead rates drop back down into place and the hidden investment in excess capacity will disappear. Companies that continually invest in new capacity can never be too sure of their understanding as to how much of their cash flow problems is due to their hidden investment.
The third possibility is low profitability. Low profitability will always produce cash problems. You can temporarily fix the problem with investing more money or borrowing but the options here will always run out. This should be your number one fear. If you are having regular cash flow problems, then regardless of how profitable your financial statements might show you to be, there is very likely a profitability problem.
Lots of smart people have managed to fool themselves as to how profitable they truly are. They might rationalize their cash problems as being a timing or hidden investment issue that will fix itself in time. They might play mind games with themselves that their old accounts receivable is collectible or that the inventory levels reported on the balance sheet are real. This kind of thinking leads them to postpone actions that might save their company from ruin.
How do you avoid fooling yourself into bankruptcy? If you are having regular cash flow problems, start with the assumption that profitability is the problem. Remember the quote from Richard Feynman “The first principal is that you must not fool yourself – and you are the easiest person to fool.”