Most small-business owners would never want their company associated in any way with Charles Ponzi. That infamous name is synonymous with business owners who try to cheat people out of their money by paying “returns to ... investors from new capital paid to the operators by new investors, rather than from profit earned by the operator.”
Unfortunately, small-business owners unknowingly run Ponzi schemes all the time with unintended consequences. This can happen when a business owner doesn't have enough cash flow from profits, reserves or loans to cover losses and ends up going out of business owing money to unsuspecting vendors and customers.
Here's how to recognize whether your small business is unwittingly operating as a Ponzi scheme and what you can do to rectify the situation before you run afoul of the law:
1. You're paying past bills with current customer cash revenue. Are you using payments from current customers to pay past vendor bills? If so, you're close to stepping across the line.
Why this happens: Your company hasn't made a cash profit in the past few months, and you now need the money you're getting from current customers to cover these losses.
What to do about it: Learn to read your cash flow statement to know exactly how much money your company is retaining or losing every month. Until your business becomes profitable, it will never be able to pay current bills from current revenue. Have the discipline to allocate payments made from current customers to pay the matching cost of goods’ bills. Do a break even analysis to determine how much cash you need to generate every month to pay all your company's expenses.
2. Your company’s quick ratio is less than one. This financial ratio is defined as current assets (cash and accounts receivables) divided by current liabilities (vendor payables, credit card payments and current loans). This figure is a measure of your business's ability to pay its current bills.
Why this happens: Companies get tight on cash and stretch out the payment of their current bills or take on temporary debt that ultimately becomes permanent to cover losses.
What to do about it: Check your balance sheet regularly to know what this ratio is for your small business. When it goes below one, check your profit and loss statement to understand why. Then take actions to improve your cash flow.
3. Your gross margins are shrinking. If you're not keeping an eye on your financial statements, these margins have may have dipped from a healthy 60 percent to a weak 35 percent or lower without you even knowing it.
Why this happens: In an effort to aggressively grow your business or combat competiton, you may have accepted less profitable business. Alternately, you may have lost track of what your margins actually are as a result of rapid expansion.
What to do about it: Look at your company's profit and loss statement, and identify the gross margin (sales minus the cost of goods or services). Determine what your profit is on selling your products or services before covering your overhead. In a services business, this should be at least 40 to 50 percent if the company wants a 20 percent EBITDA (earnings before interest, taxes, depreciation and amortization).
4. You keep too much inventory for too long a time. Many businesses have too much inventory for their level of sales. Investing in inventory requires cash, which ties up your money.
Why this happens: If you fail to track your inventory against monthly sales, you may lose track of your inventory's turnover rate. While the right amount of inventory varies by industry, it should rotate or turn at least four to six times per year.
What to do about it: Sell your inventory as quickly as possible, because the more time it takes to sell, the more cash your business requires. Take a look at how long each product is in inventory before it sells. Keep reorder points and reorder quantities low to achieve a minimum acceptable customer fill rate.
If you find that any of these four red flags describes your company, take steps immediately to remedy the situation. While you may be unintentionally running a Ponzi scheme, the law won't see it that way. Fix your problems now—before it's too late.
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