Financial Shortfall

What is a financial shortfall?

A financial shortfall refers to a company’s unpaid liabilities and financial obligations with vendors and investors that result in a temporary clampdown of business services. It is a loss amount by which current liabilities exceed the total operating cash of a company, offset through banks or private loans.

Companies experience financial shortfalls due to several reasons, like a delay in vendor or customer payments or an economic downturn.

For individuals, a shortfall occurs when monthly expenditure outgrows income. This phenomenon can make someone cut down on the majority of their monthly expenses like food, shopping, and transportation to level their pockets.

Shortfalls are also caused due to unpredictable circumstances or natural calamities which destroy a company’s logistics or supply chain operations, resulting in a loss of revenue. Having a clear analysis of financial transactions with accounting software can stabilize cash flow, bookkeep payments, and reduce shortfall risks. 

Example of a financial shortfall

Consider a furniture company that has the resources to build a thousand tables in its production outlet, as per the market demand. If a sudden drop in the demand for tables occurs, all of the raw materials go to waste and the company faces a huge revenue shortfall. Furthermore, if the demand drops after the tables reach the retail outlet of the company, the transportation and production costs get added to the set of liabilities.

If a company continues producing goods in bulk in the hope to sell at least some of them, the liabilities rise in number, resulting in a long-term shortfall. Persistent occurrence of shortfalls can push a company into grave bankruptcy as it will never have enough capital to rise up from the damage.

For salaried professionals, shortfall arises due to sudden inflation of the price of consumables or heavy family expenditures in a month like a wedding or a house renovation.

Interestingly, if a company undergoes financial shortfall, their employees also experience some form of it in their personal lives due to delays in payroll processing. 

Types of financial shortfalls

The four major types of financial shortfalls are short-term and long-term, appraisal, and budget. While the long–term and short-term shortfalls are interconnected, appraisal and budget shortfalls mainly deal with escrow payment formalities.

Short-term shortfalls happen due to an unpredictable market condition, accident, or act of nature, while long-term shortfalls may be related to poor overall cash management or financial planning. 

• Short-term shortfalls or temporary shortfalls are a result of a sudden outage in any of the company’s functional units. If one of the manufacturing plants of a company gets destroyed in a natural mishap like a typhoon or earthquake, it delays the production and transportation of items, causing a shortfall.
  
  In the example above, short-term shortfalls can be mitigated in a short period of time if the manufacturing plant shifts to a different place and investors pitch in for the loss. 
• Long-term shortfalls, also known as permanent shortfalls, cannot be fixed immediately over an accounting cycle. If an underfunded start-up starts serving pensions for ex-employees, it would lessen the rate of returns on the pension assets due to less contribution and more workforce. Long-term shortfalls take a lot of time to get rectified and need local government compensation through taxes or public fundraising.
• Appraisal shortfalls are defined as selling off an asset like a property or car at a higher cost than its original cost price and creating a need for additional funds for the buyer. If the estimated value of a home is higher than what buyers can afford, an appraisal shortfall is a way to bridge the cost gap by arranging for the required funds.
  
• Budget shortfall occurs when your funds or account anticipates less cash from tax returns or other revenue sources. Even after adding to the already existing amount in the bank account, it still fails to touch the financial bar which was originally set.

Causes of a financial shortfall 

Not every business challenge can be counted as a shortfall. Many times, businesses fail to keep up with cash flow and struggle to accumulate liquid assets for their standard business operations.

Major incidents like large supply shortages, stock market crashes or natural calamities can cause financial shortfalls. Some other causes include :

• Poaching the active clients that draw in the most accounting profit for the company.
• The mass resignation of employees due to work-related factors reduces the churn rate of departmental workflows.
• Machine teardown in one or more production units increases the setup time between production tasks, thereby slowing production and revenue.
• Supplies are managed poorly due to delays from the suppliers sourcing raw materials.
• Cost overheads and deadlines on major company projects affect implicit resources like time and labor and explicit resources like company cash.
• New income tax regulation policies initiated by the government reduce profit margins.
• Lack of pension funds leads to reduced returns on pension assets and employee agitation.
• No team of company policymakers sets rules regarding proper financial management and premiums on insurance policies.
  
• A lower number of current assets that can be converted into cash or cash equivalents during emergencies, indicates low liquidity.

Financial shortfall best practices

Leaving a shortfall situation unattended can result in dangerous outcomes as the company might run out of funds for basic expenses like the office lease or employee wages. It might leave a company with no other option than liquidating “in-service” fixed assets to pay off everything, which results in a total shutdown of the business.

However, a projected shortfall can help forecast important metrics like production costs, supply costs, warehousing, and transportation charges beforehand. Forecasting in advance can normalize the situation much faster. Some best methodologies listed below can help nix financial shortfall risks.

• Hedge funds aim to protect businesses from adverse market conditions. Companies can sell off a part of their future output in the forward market, thereby reducing financial obligations and maintaining operating cash flow for everyday business operations.
• Overdraft protection provided by banks ensures that a person can make emergency transactions of more than what they currently have in the account. Banks levy a specific interest rate on overdraft loans and allow users to repay the debt over a specific timeframe.
• Cost cutting in working employees' salaries can be an immediate measure to tackle shortfalls. Reducing an employee’s monthly salary by 25-30% or initiating a salary freeze for a temporary period of time, say one year, can help save up on company funds and resume normalcy.
  
• Equity Financing means holding back a portion of the company’s total equity (assets - liabilities), around 10% to 30%, to invest in return of capital. Individual investors, venture capitals, or initial public offerings are all forms of equity financing. As there are no liabilities or debts to repay, businesses have the freedom to channel revenue from multiple streams and fuel economic growth.
• Emergency federal reserves are an important practice that correct shortfall risks quickly. Keeping a generous reserve of cash either through tax payments or withholdings of employee gratuity can come in handy during shortfall events. These funds can be used to disburse employee salaries, pay office rent, and remit critical service payments.
• Financial statements need to be maintained to log and record important transactions over a fiscal year, which can help in the easy estimation and allocation of budgets.
• Financial institutions provide loans at zero cost EMI to organizations that can be repaid comfortably after the tough phase is over.