Managing the Cash Gap

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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.

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Cash Gap

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Do you know your business’ Cash Gap? If you do, I applaud you. It is my experience you would be the exception. If you don’t, I encourage you to read on and begin to implement this important metric.

The Cash Gap refers to the time interval between the date when a company pays cash out for the inventory it purchases and the date it receives cash from customers for the same inventory. It involves three different financial measurements: the Receivables Period, the Days in Inventory, and the Payables Period. The formula is as follows: Receivables Period + Days in Inventory – Payables Period = Cash Gap (in days). The longer the time interval, the greater the likelihood it must be financed – which adds business risk and reduces profitability via interest expense.

The Receivables Period

The Receivables Period represents the average number of days it takes to collect invoices from your customers. This is typically calculated as Accounts Receivable divided by Average Daily Sales (annual sales divided by 365 or monthly sales divided by 30). For example, if your accounts receivable balance is $200,000 at the end of the year and your sales for the year amount to $3,650,000, your Receivables Period is 20 days [$200,000/($3,650,000/365) or $200,000/$10,000].

Days in Inventory

The Days in Inventory represents the average number of days worth of sales are in the inventory your currently have on hand. This is typically calculated as 365 days (or 30 days if that is your measurement period) divided by inventory turnover. Inventory turnover is typically calculated as cost of sales divided by average inventory. For example, if your cost of sales for the year amount to $2,400,000 and your average inventory (beginning inventory plus ending inventory divided by 2) is $400,000, your inventory turnover is 6 times. Your Days in Inventory would be 61 [365 days divided by 6 (inventory turnover)].

The Payables Period

The Payables Period represents the average number of days it takes to pay your vendors for your inventory. This is typically calculated as Accounts Payable divided by Average Daily Purchases (annual purchases divided by 365 or monthly purchases divided by 30). For example, if your accounts payable balance is $125,000 at the end of the year and your purchases for the year amount to $1,825,000, your Payables Period is 25 days [$125,000/($1,825,000/365) or $125,000/$5,000)].

Given the circumstances of this example, your Cash Gap would be calculated at 56 days (Receivables Period of 20 days plus Days in Inventory of 61 days minus Payables Period of 25 days). In other words, you are paying for the inventory 25 days after receiving the invoice but not collecting the receivable until 56 days later. Next, I’ll discuss ways to improve your Cash Gap, reduce your risk, and improve your profitability.

Knowing and understanding your Cash Gap is a great way to reduce your risk and improve your profitability. 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.

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