What happens when your business doesn’t have any cash on hand? It may feel a little like the steam is running out of your engine. Cash is the lifeblood of your business. During economic downturns, many businesses find themselves with a cash shortage through no fault of their own. By understanding what your cash flow gap is and the cause of your cash flow shortage, you can identify and implement a solution.
What is a cash gap?
A cash gap is the time between when a business pays cash for the inventory it purchases and the date when it receives cash from its customers for the same inventory.
How to calculate your cash gap
The formula to determine the business’s cash gap is:
Receivables period + Days in Inventory – Payables Period = Cash Gap (in days)
The Receivables Period
The receivables period is the average number of days it takes to collect invoices from your customers. The calculation is as follows:
Accounts Receivable / Average Daily Sales = Receivables Period
For example, if you have $400,000 in accounts receivable, and your year-end sales are $4.2 million, then your receivables period is 35 days.
$400,000 / ($4,200,000 / 365) = 35 days
Days in Inventory
Days in inventory represents the average number of days’ worth of sales you have in stock. You calculate it by taking 365 divided by inventory turnover. Where inventory turnover is the cost of sales divided by average inventory. Here is the calculation:
365 / Inventory Turnover = Days in Inventory
For example, if the cost of sales for the year equals $1.5 million and your average inventory is $250,000, your inventory turnover is 6 times. Using this, your days in inventory would be 61, or 365 divided by 6.
365 / ($1,500,000 / $250,000) = 61 days
The Payables Period
The payables period is the average number of days it takes to pay vendors for your inventory. The calculation is as follows:
Accounts Payable / Average Daily Purchases = Payables Period
For instance, if you have $150,000 in accounts payable at the end of the year and your purchases for the year equal $1.75 million, your payables period is 32 days.
$150,000 / ($1,750,000 / 365) = 32 days
Using each of these equations, calculate the cash gap. In this example, the cash gap is 64 days. Found by adding receivables period of 35 days plus days in inventory of 61 days minus the payables period of 32 days. In other words, the business is paying the inventory 35 days after receiving the invoice, but not collecting on it for 64 days.
35 days in receivable + 61 days in inventory – 32 days in payable = 64 days cash gap
Once you identify the cash gap, as a business owner you can begin taking steps to close it.
Solutions to Cash Gaps
In most businesses, there is a gap between the inflows and outflows of cash. Financing is often needed to bridge this gap. This working capital funding can come in many forms. Ideally, cash from the business itself, but other options include debt or equity financing, factoring, inventory financing, among others.
The key to reducing the cash gap is to reduce your receivables period and days in inventory and/or increase your payables period. In other words, converting inventory to cash quicker while delaying payment to suppliers. Below we will discuss strategies for each of these.
Reducing the Receivables Period
There are several methods to reduce the receivables period. The basic idea is to increase the speed at which you turn materials and supplies into products, products into receivables, and receivables into cash. Here are a few techniques to do this:
- Incentivize customers to prepay
- Offer discounts for early payment
- Send out invoices as soon as possible
- Make payment options easily accessible
For instance, offering a 2/10 net 30 term to your customers will mean they get a 2% discount if they pay their bill within 10 days. Otherwise, full payment is due within 30 days.
Another method we will briefly discuss is factoring. If your business is in a tight cash crunch, factoring may be a good option. A business that offers factoring will pay you today for receivables you may not collect on for weeks or months. However, you may receive as much as 15% less for the receivables because you eliminate the hassle of collecting. This method allows you to fund current operations without borrowing.
Reducing Days in Inventory
To reduce days in inventory consider implementing a just-in-time inventory system. Rather than accumulating stock, which eats up working capital, track how much inventory will meet current demand. Sell any inventory which is unlikely to sell within the next 12 months. Negotiating better prices for inventory can also help, but beware to not sacrifice quality. Finally, creating systems to move inventory faster can reduce costs and transportation time.
Increasing Payables Period
The best approach to increasing the payables period is to negotiate longer payment terms with suppliers. Determine how long you have to pay vendors without incurring late fees or harming the relationship. This keeps cash in your account until it needs to be in the vendor’s account.
Knowing and understanding your cash gap can help you reduce risk and increase profitability. Not to mention companies with smaller cash gaps tend to experience fewer cash shortages and rely less on financing.