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EBITDA and Other Scary Words: Scary Word No. 3 – Cash

Jan 5, 2020

Well, it is only scary if you don’t have any.

So we have previously discussed GAAP and financial statements (yawn). Now it is time to get to the real reason you are in business; to make money.

If you find yourself with a large amount of money at certain points during the month and then trying to make payroll the following week, when your cash position is at a much lower point, maybe we can offer some advice to get control over your cash. Hopefully, we may even help you improve your cash gap. Wait a second; that seems like a scary word. What is cash gap?

Every business has a cash gap. It is the days of cash needed by the business to cover the time between its cash outflows and its cash inflows. The calculation is fairly easy. You take the average number of days it takes to collect your accounts receivable from your sales plus the average number of days your inventory is in your warehouse less the average number of days it takes you to pay your vendors.

So if it takes, on average, 60 days between when youreceive the inventory to when you sell it; 50 days to collect the accounts receivable from your sales; and 30 days to pay your vendors, then your cash gap is 80 days (50 days plus 60 days less 30 days). If you have $10 million in sales a year and a gross margin of 30 percent, then your cost of goods sold is $7 million. If you take the $7 million and divide by 365 days and multiply by 80 days, then you need over $1.5 million to cover the business operations. Not only do you need to have financing in place to fund your operations but you are paying interest. At 5 percent interest, you are reducing your income by over $75,000 each year because of the interest you will be paying.

Interest rates have been low for the past several years, but rates change. In a few years, the rates could be at 10 percent. Then your interest costs would be $150,000 a year.

So how can you improve your cash gap?

Knowing what it is and how to calculate it are crucial. Check, we covered that. Then you need to analyze how to shorten it. Boom, yeah, we said it, analyze it and shorten it. It’s not like it is an algorithm on quantum superpositions. Let’s take each component at a time. There are only three, so there is no chance in going over our word limit for this article.

Days in accounts receivable: Usually there are terms with your customers to pay within 30 days. It may vary within different industries. You may find offering a small discount if paid within five days can improve the average days in your accounts receivable. You may also look at your terms with your clients. Can you reduce the terms from 45 days to 40 or 30 days? For some customers, especially international customers, you should get a deposit prior to manufacturing the product or providing a service (this can get your cash gap to be a negative number).  It is imperative to constantly review your open receivable and identify slower customers. If you have slow paying customers, it might be a good idea to hire a part-time collection agent. They usually only work a few hours a month, but can improve your average days in accounts receivable.

Days in inventory and days in accounts payable: These are intertwined and can be tricky. We will talk about inventory in a future article, but we have found that when the inventory turnover is low, management does not have a good handle on the inventory. If you have one or two products in your inventory, then you should have a good idea how much inventory you should have to cover your expected near-term sales. If Product A needs 10 days to have the raw materials show up at your warehouse, and you need five days to produce a finished product, then your inventory turnover should be close to 24 times a year for Product A. If Product A has a turnover of 12 times a year, then you are ordering too much. You can reduce the days in inventory by buying less materials. By understanding the days each product is in your warehouse, you can decrease the cash gap just by having the right amount of inventory to meet your customers’ needs as well as reducing the amount you owe to your vendors. Another way to decrease your cash gap would be to change the terms with your vendors. If terms are 30 days, you may try to increase the terms to 40 days.

We hope this was helpful. Please note that when you give control over your cash accounts to your employees, you should always have controls in place to mitigate the risk for fraud. Your employees will learn pretty quickly if you are checking their work. If the proper controls and reviews are not in place over your cash, then all the work you are putting in to reduce your cash gap, generate revenue, and find financing for your operations may be for nothing.


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