Understanding and Managing a Cash Gap in your Business
Let’s look at one of the tougher challenges for many businesses; what’s commonly referred to as a ‘Cash Gap’.
1. What is a ‘Cash Gap’? It’s a lag which occurs between Income and COGS (Cost of Goods Sold). A business may still suffer from overall cashflow issues for a wide variety of reasons without specifically having a ‘Cash Gap’ problem, but we’ll leave those for another article.
2. What are the causes of a ‘Cash Gap’? Typically, the main causes are:
a) Accounts Receivable (Sales Invoices dragging out or terms are too long)
b) Too much stock (you buy $20,000 but only invoice $10,000 this month, you end up with $10,000 of excess stock you still need to pay for)
c) Accounts Payable (e.g., you are on 7 Day Net Terms with your supplier but you’re invoicing your clients on 30 days EOM).
3. How to manage a ‘Cash Gap’ in your business A word of caution, if you don’t fix a ‘Cash Gap’ and continue to grow your business, the size of the gap, in dollar terms, will only get bigger. More sales is the immediate remedy too many people first look at to fix the problem which will only fuel the fire. Try some of the following strategies to fix a ‘Cash Gap’ before you continue with growth:
1) Reduce your inventory or speed up stock turn… maybe use a simple rule of thumb or heuristic like: - “If we can’t sell it this month we don’t order it this month”. The intention is to get your team to be aware of what they are buying and the impact that has on cashflow - If you have Vehicles on the road, consider a ‘Min Max’ system, don’t drive around with stock you have paid for that you don’t need
2) Reduce your payment terms for Accounts Receivable:
- Require a deposit that is cashflow positive for your business - Reduce your payment terms, if you are currently at 30 Days EOM, make them 30, 14 or 7 days Net - For Do and Charge or smaller fixed price work, make sure it’s payment on the spot - Remember, the terms on your invoice is your ideal scenario, I have very rarely seen an invoice with 30 Days EOM paid any earlier, if you don’t ask, you won’t get! - If appropriate, charge interest on overdue invoices - Always invoice the first moment you can - Automate and systemise your collection and reminder process - If necessary, incentivise early payments with small discounts (just be aware this will help your cashflow but reduce your Gross Margins)
3) Extend terms with your Accounts Payable: - This requires trust from suppliers, some will give it a go immediately, others will need to see some history with you before they budge - Look at other suppliers who may have more favourable terms - With Subcontractors, think of them like wages that are recorded in COGS, staying on good terms with them is critical, however, you need to have the cashflow to be able to do pay them on time. Be realistic and understand the terms you have with your clients and how your cash flows. Then make sure your terms with your subbies are manageable. You may need to have a mix of terms with subbies, e.g. some on 7, 14 and 30 days Net and with bigger suppliers try to push out to 30, 45 or 60 Days EOM
4) Fund the gap with Capital, this requires absolute visibility of your business financials, typically there are three main ways to do this: - Debt: Borrow money… but be cautious, any interest you pay on borrowed money is essentially reducing your margins and profitability and if any of your clients don’t pay you, you are still liable for the loan - Equity: This is harder to achieve and much more detail involved, essentially you are raising capital through selling a piece of your business to investors or equity partners - Retained Earnings: Build your own capital through profit, many times this is the only option available for many SME’s, however, it first requires a profitable business to begin with and it takes time
5) Finally, I have mentioned this in most of my finance blogs, it is imperative you have an excellent working relationship with your accountant. If your accountant is simply doing regular compliance work for you at the moment and offering nothing else, then it’s probably worth finding a firm that can provide real strategic solutions as you grow. As a business coach, one of the first items I discuss with clients is what their relationship with their accountant is like and if they need help, I have a wide range of accounting firms who are part of my affiliates network I can refer to if needed.
Eric J. Gregory is the Author of ‘Would you like Profits with that?’ and the founder of
Gregory Business & Trades Coaching which specialises in working with SME Business Owners and Entrepreneurs to ‘Create Quality Lifestyles through Business Success’. For more information about Eric and his company, go to http://www.gregorybusinesscoaching.com.au