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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