Cash is King! You have probably heard this saying and regardless of what you think it means we all know that it is hard to conduct business if you don't have any cash. Right?
Most accountants would probably say that if you want to increase cash on hand, you either need to increase revenue and or reduce expenses. I agree with that, but I'd also like to add another way and that is to Close Your Cash Gap.
What is a cash gap?
It's the timing between your account payables vs your receivables and the revenue that it represents.
Let's say you were a contractor and you spent $1,000 cash for supplies and charge your customer $4,000 with 50% due after completion and the balance due in 30 days. Assuming it took you 30 days to complete the project, you would have a cash gap of 30 days totaling ($1,000). The contractor in this example must have enough cash in the bank to cover the $1k plus any other bills due during this time.
To close the gap we will look at two areas, accounts payable and accounts receivable. Both of these numbers should be found on your balance sheet.
I was consulting with a small business that was struggling with a cash shortage. When I looked at the expenditures and bank statements we discovered several services that the company was not using (almost $2k/mo) so we immediately discontinued those automatic withdrawals. Next we looked at the terms of each remaining vendor and picked the top 3 to contact and see if payments could be moved out by 30 days. The next step was to apply for a business credit card. When the supply invoice was due the payment could be made via the credit card extending the actual cash disbursement another 30 days.
Another organization had burned through their reserve and was starting to panic over a lack of cash. I asked to see their accounts receivables and found that they had over $75,000. Then we looked at when they were due and I found a couple of interesting problems. First, $25k had already been received but had not been accounted for. That brought their total to $50k. Of the remaining balance almost all of it was past due by over 90 days! What we did was to list the customers and contact them to find out when they planned to pay. If they never received an invoice, we invoiced them for the balance due. We negotiated a payment plan and updated the terms moving forward so that payment in full was received at the point of completion.
Going back to the original example of our contractor let's apply the changes to see how that will affect the companies cash position.
By negotiating better vendor terms he is able to order the $1k in supplies without paying upfront. The new customer contract requires 50% upfront with the balance due upon completion. By making these changes cash goes from minus $1,000 to $4,000. See the chart below.
If you play the scenarios out over 3 months assuming 1 job per month, the cash on hand for scenario 1 grows to $3,000 compared to $11,000 for scenario 2! Let's take a closer look.
Now for the new terms and condition for scenario #2. Look at the difference!
So why is this important? After all, we are just changing the timing of payments and expenses, right?
While it is true that the profit $9,000 for both scenarios will be the same, the organization in scenario 2 has less risk and more cash which potentially provides better flexibility when evaluating other business opportunities.
In real life the numbers can become significantly larger and things like compensation & benefits create additional complexities in evaluating the cash gap. Making errors on cash flow, whether in a large or small scale operation can lead to stress or even bankruptcy.
Each organization has its own cash requirements in order to operate efficiently. A once a year cash gap analysis is one way to identify opportunities to increase your cash position.
An annual cash gap analysis includes:
1. Evaluate all expenditures from high to low concentrating on the top 80%.
2. Eliminate redundancies or non value add expenses.
3. Review contracts and identify potential changes to terms and conditions
4. Negotiate new T&C's or find alternatives - buying coop, memberships, etc.
5. Evaluate all past due invoices
6. Collect outstanding balances.
7. Review customer/client contacts - terms - conditions
8. Negotiate new T&C's
If you have questions about conducting a cash gap analysis, feel free to schedule a chat.
Dwight Grant is a seasoned businessman with over 30 years of leadership experience. He lives in CO where he enjoys whitewater rafting, mountain biking and spending time with family.