Managing the Cash Gap

1 Comment

Understanding the factors that affect your Cash Gap will help you reduce your risk and improve your profitability. In my previous post, I presented a scenario where the Cash Gap was 56 days. With average daily sales of $10,000 and an assumed 30% margin on sales, the business must cover $392,000 [56 days x $10,000 x (1-.30)]. Typically, this is done with bank financing. Ideally, you would have a cash reserve sufficient enough to not require bank financing. But assuming you’re not there yet and financing is necessary, at a 10% interest rate (for ease of illustration), the interest on the financing would amount to $39,200.

If you increase your inventory turnover to 18 times per year instead of only 6, your days in inventory would drop from 61 to 20, and your Cash Gap would decrease from 56 days to 15. Again, assuming financing at 10% is necessary, and a 30% margin on sales, your business now must cover $105,000 [15 days x $10,000 x (1-.30)]. This results in interest of only $10,500, a savings (increased profits!) of $28,700. This is also a much easier scenario to manage with your cash reserve.

The key to managing your Cash Gap, then, is to reduce your Receivables Period and Days in Inventory and/or increase your Payables Period. In other words, get cash out of inventory quickly all-the-while avoiding payment to suppliers as long as possible. Here are some ways you can do just that:

Receivables Period

  • Provide incentives for customer prepayment or early payment (discounts)
  • Provide incentives for customers to pay for their purchases using a credit card (be careful here, though, as you don’t want to cause your customer to use credit cards when they can’t afford it)
  • Send out invoices as soon as a sale is complete
  • Use a lockbox account, in which customers mail payment checks directly to a PO box set up by your bank (this is also an excellent internal control)
  • Institute stricter collection procedures

Days in Inventory

  • Move towards a “just-in-time” inventory system (producing inventory to fulfill orders rather than accumulating stock)
  • Negotiate a better price for your inventory and materials – without sacrificing quality
  • Concentrate purchasing efforts on fast moving inventory

Payables Period

  • Negotiate longer payment terms with your vendors

Understanding and managing your Cash Gap is essential for business prosperity. In cases where sales grow rapidly and the cash gap is large, a company can quickly run out of cash. If you would like assistance in analyzing your company’s Cash Gap, or if you would like to learn how a part-time, virtual CFO can help transform your business using the Bible as our guide, email me at info@commonsensecfo.com or call Kirk at 402-658-7340.

Enhanced by Zemanta

One Comment (+add yours?)

  1. Long Schrenk
    Mar 11, 2011 @ 05:42:57

    This is a really great blog. Thx to the auther

    Reply

Leave a Reply

*

(Spamcheck Enabled)