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.
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