Every business experiences occasional cash shortages. When this happens, owners often assume they should go out and sell more. But this strategy can sometimes compound money troubles over the short run. Why? The answer lies in a concept known as the “cash gap.” Understanding this concept can help your business generate extra cash to meet working capital needs. Here’s how.
What is a cash gap?
The cash gap is a function of the timing difference between 1) when companies order materials and pay suppliers, and 2) when they receive payment from their customers. This difference can lead to cash shortages if the company doesn’t have extra savings, doesn’t qualify for additional bank financing, or doesn’t want to draw on a line of credit. It’s also important to keep in mind that cash gaps funded by bank financing incur interest costs.
Boosting sales generally isn’t the solution, because, when cash is tight, selling more will often widen the cash gap. That’s because the company will need to front the incremental cost of sales while new orders are fulfilled, invoices are sent and customers remit payments. This concept explains why start-ups and high-growth companies tend to experience cash shortages.
3 key focus areas to decrease the gap
If the company finances its cash gap, shaving a day or two off the gap could save thousands of dollars in interest expense over the course of a year. Minimizing the cash gap requires you to focus on its underlying variables:
There are numerous ways to minimize your investment in inventory. For instance, you might search the warehouse for slow-moving items and then either return stale items for credit, trade them with another supplier or competitor, or sell the items for scrap.
You can also revise your company’s purchasing policies. For example, some materials and parts suppliers may agree to discounted bill-and-ship or consignment arrangements in exchange for exclusive or long-term contracts.
The faster a company can get money in the door, the smaller its cash gap will be. Your business can encourage faster payments from customers by sending out past-due reminder letters and following up with phone calls. Also, evaluate invoicing procedures to minimize the days in receivables. Poor communication among billing, sales, and production staff can cause invoicing delays.
Think of trade payables as a form of interest-free financing. But, beware, there are limits to how far a company can extend its payables. Slow-paying businesses may forgo early-bird discounts or receive less favorable treatment from suppliers, such as slower delivery, higher rates, or cash-on-delivery terms. Delayed payments can also harm a company’s credit rating, as well as its reputation among its pool of eligible suppliers.
Put it to work for you
The cash gap can be a helpful management tool because it pinpoints hidden treasures in your balance sheet. Put simply, companies with shorter cash gaps tend to experience fewer cash shortages and rely less on bank financing. Contact us for help measuring your cash gap and using it to manage working capital more efficiently.