Too often, entrepreneurs believe the business will quickly generate enough cashflow to sustain operations and, thus, enter into the new business with insufficient financial resources. They may try to operate on a shoestring budget until the business reaches cashflow break-even out of necessity due to a lack of access to additional financial resources. This may involve getting behind on paying bills, which could hurt the business’s credit and relationships with suppliers and vendors. Obviously, in the absence of access to additional funding sources or lines of credit, the lack of cash also can quickly result in the closure of a business. Unexpected or unanticipated expenses can quickly lead to financial problems and growth constraints for shoestring operations. For example, the need for an additional employee to accommodate demand, but not having the funds to hire, can constrict the business’s growth and profitability.
But just as important, business growth changes a business’s working capital. For example, more sales create more accounts receivable and accounts payable. The payables can’t be paid until the receivables are converted to cash without using other cash resources. This lag can create cash flow problems for any business, particularly a startup whose financial resources often are more limited. Adequate business planning and financial analysis at the outset can help identify potential working capital needs at various critical points in the company’s growth, enabling the entrepreneur to make arrangements for lines of credit, additional capital, etc.
From a valuation perspective, businesses that operate on a shoestring budget have high operating risk, which tends to increase overall risk and lower overall value. In addition, inadequate working capital or lack of planning for working capital needs tends to increase the financial risk profile of a business and lower the value as well.