A prolonged cash shortage can quickly become a problem for companies and, in the worst case, end in insolvency. A cash shortage should therefore always be taken seriously and solved as early as possible. We show you here what the causes of a cash shortage are and how to solve them.
Cash shortage: Explanation
Cash shortage is when a company has too little cash available to cover its running costs. In other words, expenses exceed income. There can be many reasons for a cash shortage - some through no fault of your own and some self-inflicted. Here is a selection:
- Delivery problems leading to production standstill
- Declining customer demand and/or strong competition
- Suboptimal receivables management
- Lack of cash flow planning
If the company is not able to raise enough cash in a timely manner to cover its costs, insolvency is imminent. To prevent this from happening, it is important to regularly check the cash flow and plan ahead. Through accurate planning, a cash shortage can often be recognised some time in advance, so that one can react in time and the bottleneck does not arise in the first place.
Cash shortage: Formula
In order to calculate the cash a company has available at a certain point in time, one compares all revenues with the expenses:
Total Cash = Sum of all incoming cash flows - Sum of all outgoing cash flows
If this result is negative (expenses are higher than income), there is a cash shortage. If the result is positive (income higher than expenditure), there is a cash overage.
Cash shortage: Example
An enterprise prepares a cash flow statement for the past months:
| Incoming cash flow | Outgoing cash flow | Total Cash | |
|---|---|---|---|
| May | £200,000 | £150,000 | £50,000 |
| June | £150,000 | £160,000 | £-10,000 |
| July | £180,000 | £160,000 | £20,000 |
In June there is a cash shortage, in May and July a cash overage. As long as the shortage can be compensated, there is no reason for concern. The only thing to avoid is that shortages do not occur regularly, otherwise it will become increasingly difficult to cover running costs.
Cash Shortage and Overage: Meaning for businesses
Cash shortage consequences
The above example already shows the importance of cash for a company: It serves to keep the operative business running. If the expenses very often exceed the income, the liquidity reserves of a company will be depleted over time. Once these are used up and the bottleneck persists, insolvency threatens.
In this case, the company must raise cash to continue to cover its costs, either by selling assets or by taking out a bank loan. However, if the company is already severely distressed, the prospects of obtaining a loan are slim.
As soon as a cash shortage is identified, companies should react and try to either avoid the shortage altogether or at least mitigate its impact.
Cash overage consequences
If a company regularly has higher revenues than expenses, this is first of all a good sign, because it means that its business model is working and customer demand is high.
However, if companies accumulate very high amounts of surplus cash, they are giving away potential. If cash is just lying around in a bank account, it is not working for a company. While building reserves is important, further thought should be given to very high surpluses.
Once you have built up sufficient reserves, you can use the further cash surpluses, for example, for investments or to expand the business model. In this way, the cash effectively contributes to the company's growth, increases turnover and profit.
How to solve cash shortage
If the case of a cash shortage has already occurred, quick action is called for, because solvency must be ensured at all times in order to avoid insolvency. First, the severity of the shortage must be assessed. Ask yourself the following questions:
• Can we generate enough revenue by selling off stock to absorb the cash shortage? • Can we sell financial assets to ease the bottleneck? • Do we need a bank loan? If so, can we estimate how long the cash shortage will last?
If the cash shortage is not yet acute but foreseeable, you have more time to act. The earlier you recognise the shortage, the better. In order to reduce the risk of a cash shortage, you should do everything possible to have enough cash available at all times, even in good times. There are many ways to do this.
Build up reserves for at least 6 months
Use cash surpluses to build up reserves. We recommend that you build up a cash cushion so that you can cover your expenses for at least 6 months without having to take out a loan or sell assets. If a cash shortage then occurs, you have 6 months to implement measures to alleviate the shortage.
Shorten payment periods for customers
If your customers pay by invoice and you give them a long time to pay, this can lead to a cash shortage because you have to wait longer for your revenue. If possible, encourage your customers to pay in advance rather than on account. If this is not possible or not desired, choose the shortest possible payment terms.
Extend payment terms with suppliers
If you have the opportunity, talk to your suppliers and ask to extend payment terms. You may be able to negotiate new delivery terms so that this is possible and does not negatively impact your cash flow. Also get quotes from other suppliers so that you have the widest possible choice.
Use factoring
When you sell your receivables to a factoring service provider, you get paid immediately. This means that no matter how long the invoice payment period is, you get your money immediately, giving you more cash to work with. Factoring does cost a fee, which reduces your profit, but it can be a good way to speed up your incoming cash flow in times of low turnover.
Monitor and plan ahead for cash flow
In the long term, you can reduce the risk of a cash shortage by regularly monitoring your cash flow and preparing a cash flow plan. In the planning, you take into account expected future developments in your business and then see how they will affect your cash flow. If a cash shortage is imminent, you can see it several weeks in advance and have more time to act.
