With uncertain conditions and increased volatility in the U.S. economy, businesses looking to grow and improve profitability will need to understand their anticipated cash flow needs and choose the most effective strategies to prevent or address cash flow gaps triggered by growth.
A cash flow gap arises when a company’s expenditures exceed the funds that are coming in, resulting in a shortage of cash on hand. This can occur, for instance, when a company’s expenses are due before it receives payment on its outstanding customer invoices.
If, say, expenses must be paid on the 15th of the month, but customers don’t pay until the 30th, the company will need to cover expenses in the latter half of the month without the benefit of incoming cash. In this situation, the company may struggle to meet its obligations, or it may need to borrow short-term funds to cover outstanding expenses.
Common Cash Management Strategies
Bootstrapping
Bootstrapping occurs when a company uses its existing resources to self-sustain its cash flow needs to promote and develop the business. Sources of funds and activities commonly associated with bootstrap financing include personal savings, family loans, purchasing used equipment, bartering, leasing real estate and property, or obtaining advanced deposits.
The key advantages of bootstrapping include:
- The owner maintains equity and decision-making power in the business.
- The company will have less debt and won’t have to pay interest on borrowed money.
- The company will look more desirable to outside lenders and investors should its efforts prove successful.
The potential disadvantages include:
- The owner is forced to come up with all the financing.
- Growth speed can be limited.
- Operations may suffer due to financial resources being tied up in revenue-producing activities.
- Operating on low levels of capitalization requires additional time and resources.
Debt Financing
Debt financing is when companies or individuals borrow money from a lender with terms to repay the loan plus interest. Common sources of debt financing include credit cards, loans from banks or financing companies, loans from private debt investors, or capital leasing.
The key advantages include:
- The owner maintains equity in the company.
- Tax deductions are allowed for interest on the loan.
- Debt obligations are limited to the principal balance and interest over the defined term of the loan.
The potential disadvantages include:
- Liability for repayment.
- Potentially high interest rates.
- Negative credit rating impact.
- Having to provide collateral on certain loans.
- It may be viewed as a high risk by potential customers or investors.
Asset-Backed Debt Financing
Asset-backed debt financing can allow companies to maximize their borrowing capacity by pledging collateral. For businesses without strong balance sheets or historically profitable operations, this may be a preferable approach to establishing or rebuilding credit with a financial institution.
Asset-backed lending works well for manufacturers with seasonal volume spikes or highly variable industry cycles that can disrupt their cash flow. Such businesses may experience rapid growth at certain times and have well-performing receivables. However, they may lose out on opportunities due to undercapitalization.
Factoring
Accounts receivable factoring is a form of asset-backed lending commonly used by manufacturers. A factoring transaction occurs when a business sells its accounts receivable to a financing company at a discount in return for immediate payment.
Although the business will not receive the entire amount of the original receivable, the financing should allow for larger volumes of sales to occur while the company builds working capital to grow.
This is often the most expensive form of cash flow, but if other options are not available, factoring can provide the working capital a company needs.
Regardless of whether factoring is an option or not, decreasing the collection time of receivables should always be a focus.
Cash Flow Gap Strategies Summary
Numerous cash management options can be implemented as part of a company’s strategy to combat the cash flow gap. One aspect they share is that they take time to initiate.
As the outlook and shape of the banking industry have changed in recent years, companies need to evaluate their available options and be prepared to implement a concerted solution as growth opportunities emerge.
Companies should prepare a cash flow forecast to understand best how much cash is needed to fuel growth. Contact us today to learn more about a cash flow gap and see how we can help.
