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Article: Shrinking the Cash Flow "Gap"

By Steve Scoggan

The number one problem for businesses in a tough economy is cash flow.  A key to addressing this problem is understanding how cash flow works, and then taking steps to improve it.  
 
As the economy has slowed, many businesses have dealt with the following challenges:

Reduced revenues
Lower gross margins
Slow paying customers
Growing inventories
Tight credit

Individually, each one of these items can significantly affect cash flow.  However, many businesses are dealing with the effects of more than one of these challenges simultaneously, and are feeling the pinch.
 
An effective process to improve cash flow includes:
1)    Understand where you are (quantify the problem numerically)
2)    Take action
3)    Study the effects of those actions by studying the changes
       in 1)
4)    Go back to 1), 2), and 3) for continual improvement
 
What is the "Gap"?
There is a simple way to quantify cash needs in a business.  At any given time, how much cash (or credit) does a business need to comfortably operate?  What is the difference between the cash tied up in accounts receivable (the sale has been made, but the cash has not been collected) and the cash payments delayed in accounts payable (the raw materials or labor have been used, but the bills have not been paid)?  How much of a cushion (in cash and credit) does a business need to have available so the owner sleeps well at night? 

Let's call this amount of money the "Gap" – it represents the difference between the timing of money coming in and money going out.  

The "Gap" can be calculated very simply:

"GAP" IN DAYS = Accounts Receivable (A/R) days* – Accounts Payable (A/P) days**

"GAP" IN DOLLARS = GAP" IN DAYS X Average Daily Sales

* - A/R days = (Accounts Receivable/Revenues)   X 365 days

** - A/P days = (Accounts Payable/Direct Costs) X 365 days

Note: if revenues or direct costs are for a period of less than a year, reduce the number of days multiplier accordingly.

Example

A company has had some collection challenges recently, with A/R days currently at 61 days.  However, vendors are paid timely, with A/P days currently at 35 days.   Therefore, the"GAP" IN DAYS is 26 days.  

Annual revenues are $18 million, or about $49,000 per day.   So, "GAP" IN DOLLARS is about $1.7 million (35 X $49,000).

A credit line (usually maxed out) of $1.2 million is available.   Cash balances are usually less than $500,000.   This company is experiencing cash flow challenges.   Owners or investors are making up the deficit somehow, either putting in additional cash, utilizing credit cards, postponing payments and stretching payments to vendors.  It is difficult making payroll.

Company management must understand the cash flow cycle, and be able to quantify these measurements.  Then, they must go to work, set goals for improving those measurements, and keep their eye on the ball.   If, over a period of time of concentrated effort, they reduce A/R days by 10 days, this would produce $490,000 in additional cash!

There are different nuances to calculating the "Gap" depending on your industry and financial make up.   Inventory or work in process can also be culprits that tie up cash and should be measured and monitored.   Again, understanding your specific company's cash flow model is the place to start.

What can businesses do to improve cash flow?   First, if your company is experiencing cash flow challenges, start tracking the "Gap" on a weekly or monthly basis.   In addition, a checklist with some questions that can stimulate thoughts and actions that can improve cash flow is included here.   If you would like help designing a cash flow measurement system for your company including a "Gap" analysis, please contact us (sscoggan@leverich.com) for additional information.   After establishing where you are, we can help you determine specific ideas for improvement, and coach you to make sure it gets done.   Through concentrated, focused effort, these actions can whittle away at cash flow challenges, and SHRINK THE "GAP"!

Checklist

Do you discuss and negotiate payment terms with key vendors?

Do you review large variable expenses such as insurance annually in advance of when they come due, and seek competitive bids?  

Do you attempt, wherever possible, to get deposits from customers before work begins?

Do you have processes and procedures to get bills to customers as quickly and accurately as possible?

Do you follow up, preferably by phone, with customers immediately when they have exceeded their payment terms (or maybe even the week before payment is due)?

Do you have employees, such as sales people and project managers, that have some of their compensation tied to successful collections?

In times of tight cash flow, have you discussed discounts with customers for early payment?

Do you give different terms to different customers based on informed credit checks?

Do you focus on completing jobs as quickly and efficiently as possible?

Do you monitor payables on a monthly or weekly basis to take advantage of discounts and special terms?

Do you work with your CPA or tax preparer to minimize and plan tax payments based on tax law?  

Do you have a relationship with more than one bank?

Do you forecast and monitor cash inflows and outflows regularly?

Do you track the "Gap" or other liquidity or leverage measures regularly?