While most business owners understand the importance of cash flow, not everyone knows how to identify a cash flow gap and the negative effects it could have on the business. We sat down with Kirk R. Rowland, CPA and owner of CommonSenseCFO, and talked about how to first identify a cash gap and some ways to close it.
Small Business Center: What is a cash flow gap, and how can it be detrimental to a small business?
Kirk Rowland: The “cash gap” refers to the time interval between the date when a company pays cash out for the inventory in purchases and the date it receives cash from customers for the same inventory. This can be detrimental to a small business by requiring the owner to cover the difference. Typically, this is done with bank financing, which leads to increased risk and additional interest expenses. Ideally, you would have a cash reserve sufficient enough to not require bank financing. Another potential option is receivable factoring, but this hurts the small business in the end by incurring additional expense in the form of factors’ fees.
How can business owners identify a cash gap in their business? Can you describe the process?
Determining a cash gap involves three different financial measurements: the receivables period, days in inventory, and the payables period.
You can use this formula to determine your cash gap:
Receivables Period + Days in Inventory – Payables Period = Cash Gap (in days)
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 $3.65 million, your receivables period is 20 days:
$200,000 / ($3,650,000 / 365) = 20
The days in inventory figure represents the average number of day’s worth of sales that are in the inventory you 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 amounts to $2.4 million 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, or 365 divided by 6.
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 million, your payables period is 25 days:
$125,000 / ($1,825,000 / 365) or $125,000 / $5,000
In this this example, the cash gap is 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.
Once a cash gap has been identified, what are some steps business owners can take to close it?
The key to managing your cash gap is to reduce your receivables period and days in inventory and/or increase your payables period. In other words, you want to get cash out of inventory quickly — while delaying payment to suppliers as long as possible. Here are some ways you can do that:
To increase your receivables period, you can provide incentives for customer prepayment or discounts for early payment along with incentives for and the option to pay using a credit card; send out invoices as soon as a sale is complete; use a lockbox account, in which customers mail payment checks directly to a P.O. box set up by your bank (this is also an excellent internal control to prevent fraud); and institute stricter collection procedures.
For days in inventory, you could move toward 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, and concentrate purchasing efforts on fast-moving inventory.
For the payables period, the best approach is to negotiate longer payment terms with your vendors.
As a CPA, what are some of the biggest mistakes you see that lead to cash flow gaps?
Some of the biggest and most frequent mistakes I see that lead to large cash flow gaps include accumulation of excess inventory and materials, lackadaisical collection efforts, delayed invoicing of customers, and accepting short payment terms with vendors.