Managing the Cash Gap

EXECUTIVE SUMMARY * THE CASH GAP IS a simple concept that helps operating people understand how their actions affect a company's cash flow. It is easy to illustrate with a simple diagram. * FOUR BARS ON A TIME LINE are all it takes to get the point across. The first represents days of inventory, the second the days of payables, the third the days of receivables, and the fourth--which is determined by the relationship between the first three--is the cash gap. * INTEREST COSTS PER DAY OF CASH GAP can be calculated readily. For each day the cash gap is reduced, the daily interest cost saved flows through to pretax profits. * THERE ARE ONLY THREE WAYS TO REDUCE the cash gap: increase the payables period; decrease the collections period; or increase inventory turnover. Tradition and the nature of the business often set the typical cash gap in a given industry. Some industries have inherently higher cash gaps than others. * GROWING COMPANIES MUST MONITOR THE CASH GAP along with sales growth and profit margins, or they will encounter cash shortfalls. How to help operating people use working capital wisely. CPAs and other financial executives know how important effective cash management can be to a company's bottom line, but they sometimes have trouble convincing operating managers to pay sufficient attention to cash flow. Financial people need to make an effective case to win over the operating crew--even those who otherwise might be very good at managing sales, production, inventory or materials may need some persuading. The "cash gap" is a simple concept that does the job. PICTURE IT The cash gap is the number of days between a business'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, inventory days on hand + receivables collection period - accounts payable period = the cash gap. That interval must be financed. The longer the time difference, the more interest a company must pay. Even when interest rates are low, the cost of financing can add up quickly. When operating decision makers see this picture, they understand and can readily be persuaded to shorten that time span. Although a desirable cash gap varies with economic sector, geography and season, the concept can be used to improve cash management at any company, no matter what the industry. Exhibit 1, part A, page 28, is a cash-gap diagram for the fictitious High Tech Widget Co. To draw the diagram, start with a time line in days. [EXHIBIT 1 ILLUSTRATION OMITTED] Assume that High Tech Widget turns inventory six times per year. In other words, it has about 60 days of inventory. This is calculated in the usual way--365 days divided by inventory turnover, with inventory turnover calculated as cost of sales divided by average inventory. Now look at the green bar in part A of exhibit 1. That depicts how long inventory is on hand. The green bar above the time line begins when the inventory arrives and ends when the inventory is shipped as product, in this case 60 days. Inventory activities always belong above the time line. Next, consider High Tech's payables. Say it pays its accounts in 30 days, on average. The blue bar below the time line represents this. It starts on the day the inventory arrives (the left end of the green bar above the line) and ends on the day the check for the inventory leaves the company, in this case day 30. Then look at the yellow bar representing receivables. Say High Tech collects its receivables in 60 days, on average. Below the time line, the yellow bar begins the day the inventory leaves the company (the right end of the green inventory bar, or day 60) and ends when cash is received from the customer. The red bar, which is below the blue payables and yellow receivables bars, begins where the payables bar ends, and extends right to the point where the receivables bar ends. …