‘Know Thy Numbers’ Installment #4- Cash is King: Cash Gap and Working Capital

Calculating and Closing the Cash Gap

So, assuming you’ve read our prior installments, you’ve learned about the basic tenets of GAAP (Generally Accepted Accounting Principles) and the different types of financial statements (yawn)…. Now, it is time for a sexier topic: cash.. Dough. Green. Coin. Moolah. Cabbage. Clams. Scratch.  And we cover how to calculate the cash gap (and working capital gap) and how to close that gap.

Defining Cash Gap

What is cash gap? Every business has a cash gap. It is the number of days that the business requires cash to cover the time between its cash outflows and its cash inflows.

Let’s say your business finds itself with a large amount of cash after a robust day of business or after a particular transaction, spends all that cash on inventory the next day, and then struggles to make payroll the following week because it doesn’t have enough cash.

If this happened, then you’re an idiot (ok, well you may not be an idiot, but you did make a mistake), because you failed to properly take into account your company’s cash gap.

As the subway announcement says, you have to mind the gap. Understanding your cash gap is critical if you are going to efficiently manage your company’s cash flow.

Defining Working Capital Gap

First, you need to know the difference between working capital and cash flow. Cash flow is a function of the amount of cash your business generates and spends in any specific period of time. This allows you to understand how much cash you have for everyday business expenses. You need to understand your company’s cash flow in order to understand what it’s working capital is, but they are not the same thing.

Working capital is defined as current assets minus current liabilities:

WC = Current Assets – Current Liabilities

Focusing on your working capital requires you to consider how your current debt compares to your current assets. This, in turn, requires you to consider what debts are due within a short period of time (the next 12 months is the standard) and what assets are expected to be liquidated quickly enough to pay off those debts (e.g., accounts receivable).

Understanding what your working capital gap is (or is expected to be) will tell you whether or not your company can pay its short-term obligations as they come due. If your math tells you that the answer is no, assuming you do that math sufficiently ahead of time, then you can make changes (e.g., borrowing, reducing costs) to avoid a bad situation (or, in many cases, existential crisis).

How to Calculate Cash Gap

The calculation is fairly easy. You take the average number of days it takes to collect your accounts receivable from your sales (Days Accounts Receivable or DAR) plus the average number of days your inventory is in your warehouse (Days Inventory or DI), and then you subtract the average number of days you have until you need to pay your vendors (Days Account Payable or DAP).

DAR + DI – DAP = WCG (cash gap)

So, if it takes an average of 60 days between when you receive inventory to when you sell it, 50 days to collect on your A/R from those sales, and you have credit terms that give you 30 days to pay your vendors, then your cash gap is 80 days.

50 (DAR) + 60 (DI) – 30 (DAP) = 80 (WCG)

But how much money will you need to cover this cash gap?

Let’s assume you have $10 million in sales a year and a gross margin of 30%. This would mean your cost of goods sold is $7 million and that you should have $3 million with which to pay all of your company’s other expenses and hopefully earn a profit.  But you are not going to collect the $7 million at once and, so you will not have the $3 million at once. You need to make sure you have the cash to operate while you wait for collections to come in. So, what do you do?

Divide $7 million by 365 days. Then multiply that by 80 days. The math tells us that you need about $1.534 million to cover the cash gap attributable to your purchase of inventory. This, of course, assumes cash comes in evenly, which is not usually the case (unless, perhaps  you are Netflix or another subscription business that does not have too much net customer loss). This is especially not the case if your business has a lot of seasonality.

Whatever the cash gap, you need to either have enough working capital or enough financing in place to cover it. Read Business Borrowing Basics — Negotiating A Loan Agreement or purchase the Financial Poise Webinar series, Borrower or Lender Be to learn all you need to find and negotiate appropriate financing for your business.

Time to close the gap.

How to Improve Your Cash Gap and Increase Working Capital

Whatever your cash gap is, making it shorter is always a good thing.  How might you do that?

• Accounts Receivable – Can you collect your A/R faster?
• Inventory – Can you move closer to just-in-time inventory purchasing?
• Accounts Payable – Can you get longer terms with your vendors?

Read Installment #5: Understanding Accounts Receivable

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[Editor’s Note: Browse all installments of Know Thy Numbers/Know Thy Business, starting at the beginning with ‘Know Thy Numbers’ Installment #1 – Welcome to the Jungle, an Introduction to the Series

To learn more about this and related topics, you may want to listen to the following webinars:

• The KPI – Cash Flow Modeling and Projections
• Where Did All My Profits Go? Mastering the Concept of Working Capital.]

©2021. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.