We see businesses go belly up every day. Out of them, most are startups. The reason for a start-up to go out of business makes perfect sense. There are so many things that could go wrong in a startup. And we are familiar with them, therefore we don’t get stunned by such cases. However, we think that ones you are done with the rough waters, in the beginning, ones you start sailing, the possibility of a company going bankrupt is minimal.
Nevertheless, we see very successful companies suddenly go out of business leaving hundreds of people without an occupation. The impact of such closures could do are much higher. Therefore, we believe that there has to be some sort of security that protects such companies from falling apart.
While this is true to some extent, there are some instances, where there is no security whatsoever. In most instances, such problems take down companies with little to no warning. One such instance is when a company experiences large negative cash flows due to rapid scaling. This is how unprecedented success could potentially ruin your business.
Imagine you own a coffee roasting company. You start it with your brother as a side hustle. Due to the strong interest you have on coffee, you two come up with a good quality product which your consumers start to like. First, you sign a deal with your local coffee shop to supply 10kg of coffee every month for $10 a kilo. You take a small loan from your parents to buy a machine that could help you in this production. Even though your parents are generous enough to give the loan interest-free, they still expect you to pay the initial sum. Now every month, you make $100 out of business. Out of that, you pay back $40 to your parents. Leaving you with a good $60 remaining. But the coffee beans cost another $30 and electricity and packaging cost you an even $10 leaving you with only $20 at hand.
Now, thanks to the wonderful marketing skills of your brother, a large chain of coffee shops come on board with a deal asking for 100kg of the finest of your coffee every month. With this order, you have to buy a much larger machine to cater to this and even have to invest in packaging. You also had to recruit a part-time administration officer to keep the books in line. The new machine costs a fortune, you went to a bank to borrow the cash you need.
Same as any other larger company, the new coffee shop chain wants a 3 month credit period on the settlement. Now you need to get to supply $1000 worth of coffee every month. Sounds like a good plan right? But the first payment from the company comes 3 months after your initial investment. Meaning, you need to spend $300 on raw coffee beans plus about $100 more on other expenses. On top of that, you need to settle the monthly installment of $200 on your new loan. You spend $600 every month, for 3 months to get the first pay cheque of $1000. This is what you call a negative cash flow.
You need to hold up with this negative cash flow for a good 6 months to see some profit in the company. Now, this might cripple your business. But you are ambitious enough to hold it together for these 2 quarters. The same ambition on you attracts even more business demanding more inventory. More business is good, right? That means you are doing something the right way, isn’t it?
As soon as the deal starts if you forecast the year-end, it surely shows a net profit. But, more orders mean more cost and no cash inflow. The accumulated negative cash flow will eventually exhaust you and ruin all that you built.
Therefore always be mindful when expanding. All good business opportunities might not be as good as you expect.