We see it all the time: businesses that are flush with cash face sudden financial challenges that catch their owners completely off guard.
This reaction is understandable. Most business owners hear the phrase “cash is king” over and over again. And it’s not entirely wrong. Just about any business would like to be a high cash flow business.
But what happens when we challenge that notion?
It doesn’t take long to uncover the hidden traps and some unexpected consequences of high cash flow.
Cash Can Be Misleading
Cash can be misleading, and high cash flow businesses can lure business owners into a false state of security. Ultimately, a bank balance is nothing more than a rearview look at your financials up to today. It doesn’t tell you what will happen in the future and how the cash will need to flow through your business going forward. Business owners who make decisions based primarily on their current cash flow face a major risk: failing to anticipate future liabilities.
Skyrocketing Insurance Rates
Chances are you have cash that will be owed somewhere down the road. What’s in your account today isn’t actually yours to hold onto. Say you’re in a high-risk industry, and your insurance rates suddenly go through the roof. If those rates are paid out annually or quarterly, the payment won’t immediately register in your account. But you’ll certainly need to plan for it, and your cash flow will take a hit. Do you have the foresight—and the financial insight—to plan ahead for that kind of scenario?
Deferred Revenue
When a company takes upfront payments for work to be completed in the future, it inflates cash but then leaves a liability on the balance sheet. That’s called deferred revenue, and it can create a dangerous perception for business owners. As work is completed, the company is recognizing revenue but not receiving cash for it. So even though revenue may be increasing on the company’s income statement, cash is stagnating or decreasing because the payment tied to that revenue was already received. Deferred revenue often creates problems for companies that use annual subscriptions, like SaaS companies. If they sign up a large number of customers upfront but don’t properly forecast the cash outlays in the following months, they can be caught without the cash they expected to have on hand.
Compensation Payments
Bonus compensation and payments to third-party contractors are similar liabilities to consider. These payments aren’t always neatly doled out every single month; you might pay bonuses in a lump sum at the end of the year, or incur higher contractor costs at certain phases of a project. How closely are you tracking these payments to anticipate what you will owe and when?
Similarly, business owners must be able to monitor the distributions they draw from the business for themselves. Many owners put distributions on a “set it and forget it” model, but as the business evolves, owner draws may need to adjust accordingly. For example, increased labor and material costs could decrease a company’s profit margins—and owner draws may now be too high for the new level of profitability in the business.
Seasonal Ups and Downs
Seasonality is another crucial factor for businesses to take into account. Companies that are flush with cash in Q4 often receive advice to spend significant sums as a strategy for reducing their taxes. While such approaches can be effective, they also need to be thoughtful. If you make investments in Q4 that tie up your cash, but Q1 is your slowest quarter for sales, you could end up in a situation where you’re struggling to make payroll—a problem that could have easily been avoided.
Businesses that only operate during specific seasons can also run into cash flow traps related to inventory management. Suppose you run an ice cream stand that operates during the summer months. You look at your bank balance in mid-July, and you seem to have plenty of cash, even more than you anticipated. You make some new investments, hire another team member…only to realize that you hadn’t factored in your inventory. There are 6 weeks left of summer, and you’re almost out of sugar cones. If you don’t allocate enough cash to restocking inventory, your profits will quickly start to decline.
High Cash Flow Businesses Face Opportunity Costs
Even businesses that aren’t overlooking future financial liabilities can face unexpected consequences associated with high cash flow—mainly in the form of opportunity costs.
It’s human nature that when times are good, whether in business or life, people become complacent. A business owner’s risk tolerance increases. They aren’t especially concerned about how to do more with less, and they tend to overbuild instead of prioritizing efficiency and profitability.
In doing so, they fail to acknowledge a simple truth: that doing more with less (i.e., optimizing efficiency) is always a good business practice. Cash flow can change suddenly due to factors outside your control, such as rising interest rates or the loss of your biggest client. You certainly don’t want your company on the list of major US companies that have laid off staff in 2024—a common consequence of overbuilding when cash flow is high.
Instead, focus on building a cash reserve. Obtain a line of credit (LOC) (it’s easier to acquire an LOC when your business is profitable; so don’t wait until a downturn to seek one out). Finally, adopt a mindset of efficiency and continuous improvement during good times and bad.
How to Understand Your Cash Flow
Compass East works with many clients to help them gain a better understanding of and manage their cash flow. We start by building a three-statement model for the entire year that includes the income statement, balance sheet, and cash flow statement.
We utilize both top-down and bottom-up budgeting to build out the client’s projections. Top-down budgeting involves analyzing historical statements and a high-level chart of accounts to determine financial goals. Bottom-up budgeting involves creating granular department-level budgets, broken down monthly.
These deliverables inspire strategic conversations about making the right business decisions and avoiding the pitfalls associated with high cash flow.
Want to know what you can do now to understand your cash flow better? Follow these quick tips:
- Adopt a 13-week cash flow model, the standard best practice for evaluating a business’s overall financial health and predicting future cash flow.
- Pull a monthly cash flow statement along with your P&L and balance sheet to see how your cash flow affects the business and vice versa.
- Rely more heavily on your reporting than your bank account, acknowledging that the former provides a more meaningful read of your cash flow.
- Communicate about any non-routine owner draws so your team can include that in their forecasting and reporting.
Interested in getting help with your company’s cash flow? Book your consultation with our team to start the conversation.