EPASS International - Topics

The Cash Gap

A cash gap is created when a company pays its suppliers and subcontractors before it gets paid by its customers. It is measured as the number of days between a company's payment of cash for goods and services bought and the receipt of cash from its customers for goods or services sold. In other words it is the inventory period + receivables collection period – payables period. This cash drain must be financed.

Cash gaps that are close to zero are desirable. When a company is able to purchase inventory, sell it and collect payment on the sale in the same amount of time it takes it to pay for the inventory, the cash gap closes to nil.

Unfortunately, it is not uncommon to hear about new companies with booming sales that grow themselves right out of business. Often newer companies simply lack the power to negotiate payments terms with established suppliers. Expansion efforts stall and continuing operations are placed in jeopardy when bills are paid weeks before cash from sales eventually trickles in from customers. Such firms require a significant amount of external financing in order to support their ongoing operations.

If both the cash gap and sales are growing, a company rapidly reaches a point at which cash outflow exceeds inflow—a situation that can quickly lead to bankruptcy.

Financing the Gap

In order to illustrate the cost of financing the cash gap, consider the following example of a company engaged in the sale of promotional items.

The company spends an average of KShs 273,973 per day on its operations, it takes about 30 days to import branded promotional items from China, it’s Chinese supplier gives it 15 days credit, and it takes about 60 days for the company to get paid on sales. This firm will require KShs 20,547,945 in financing to support its operations. If the finance charge on its overdraft is the base rate plus 4.5%, its annual cost of financing is KShs 3,698,630.

Annual Sales:

Operating Cost [Cost of Goods Sold + Overheads]:

Daily Operating Cost [Operating Cost / 365]:

Cash Gap [Inventory + Collection – Payables]:

Financing Required [Daily Operating Cost x Cash Gap]:

Overdraft Rate:

Annual Financing Cost [Financing Required x OD Rate]:

If the company can find a way to reduce its cash gap to say 50 days, it can reduce its annual financing cost significantly, to KShs 2,464,753.

Closing the Gap

There are only a handful of ways a company can reduce its cash gap. They include:

Focusing on the sale of fast-moving merchandise

Offering discounts to customers who pay early

Encouraging customers to make down payments

Stretching out payment terms on purchases of inventory

Special Constraints Facing SMEs

Small businesses face a number of operating and financial constraints that limit the extent to which they can shrink the cash gap. Many face technological and managerial constraints that limit their ability to closely monitor inventory levels. Many SMEs lack the power that large corporations have in stretching out payment terms from suppliers. The majority of small businesses do not possess adequate human and technological resources to devote toward the effective collection of accounts receivable. These small firms typically have limited access to short term financing alternatives to help short-term working capital needs. Obtaining working capital from banks is frequently a difficult, time-consuming, and paper-intensive process. And of course, willing lenders are often hard to find.

150,000,000

100,000,000

273,973

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