Decoding Accounting – The Cash Gap

Cash flow is vital to small businesses, more so than almost any other metric or measure.  Working capital and positive operating cash flow are also areas where many small businesses struggle.  In this article, we’ll take a somewhat simple concept and strategy called “cash gap” and explain how it can work for your business.

The cash gap is the time between when a business pays for expenditures and is paid from its customers.  There are three primary components involved in calculating a companies cash flow gap; accounts receivable, accounts payable, and inventory.  If this measure is left unchecked, it can make an ordinarily profitable business struggle with cash flow.  Let’s walk through each component.

Days Sales Outstanding

Days sales outstanding or “DSO” is the measure of the average number of days it takes for a company to collect payment on a sale.  For instance, if you sold a product today, but it takes you 30 days to collect a the payment, your DSO would be 30.  The formula to calculate days sales outstanding is:

Total Days x (Accounts Receivable / Total Credit Sales)

Companies that manage their cash flow diligently, manage their DSO as well.  If you ever wondered why companies will often give you a 2% discount for paying within 10, it is to manage their DSO.  Companies use strategies to either enforce or entice quick payment.

Days Payables Outstanding

Days payables outstanding or “DPO” is the measure of how long it takes you to pay your vendors (we’ll have another article on this, but you should be stretching this out).  For instance, if you received a bill today, but didn’t pay it for 45 days, your DPO would be 45.  The formula to calculate days payable outstanding is:

Total Days x (Accounts Payable / Costs of Good Sold)

This formula is not as straight forward as the one above, so let’s dive into it a little more.  Average accounts payable can be calculated simply by taking the balance for accounts payable at the beginning and ending day in a period (say a year) and dividing by two.  Cost of goods sold is merely the purchases over that same period.  For a service company, DPO might include all third-party expenses. DPO can be a little trickier to calculate because there is some thought that must be put into which expenses (or costs of goods sold) should be used in the calculation.

Managing your DPO is a tricky tight rope to walk.  A high DPO is generally advantageous for a business. If it takes longer for a company to pay its creditors, the cash on hand could potentially be used for short-term investing activities. However, taking too long to pay creditors may result in unhappy creditors and their refusal to extend further credit or offer favorable credit terms.

Days Sales in Inventory

Days sales in inventory “DSI” on hand is a measure that tells you how long it would take to sell all of the inventory you currently have as of now.  The days sales in inventory formula is calculated as follows:

Total Days x (Inventory / Costs of Goods Sold)

One quick note, the cost of goods sold should be taken over the same period as total days – in other words, if you use 365 for total days, you should take the expense over that period of days.

A business that has too much inventory can create major issues for themselves by tying up their working capital.  Likewise, you must have enough inventory on hand to satisfy customers need.  The right amount of inventory to hold on hand varies by industry and can be impacted by things such as the availability of raw materials and the length of the manufacturing process (if any). 

What does this mean for my business?

First, you may be looking at this and saying “I don’t have inventory, this isn’t relevant to me!”.  You would wrong.  Your cash gap would simply not include inventory. 

You may be saying, “my customers pay me via cash or credit card at the time of sale, this isn’t relevant to me!” Sorry, again you would be wrong.  Your DSO is simply either 0 or 1 days (however long the merchant provider takes to pay you). 

Cash gap is relevant to all businesses.  Some businesses inherently operate with a negative cash gap.  Those businesses must figure out a way to fund their purchases prior to receiving money from a customer.  They must also consider their financing costs when setting a price on their products.

These financing methods only work for so long. Upon receiving money from a customer, the business owners can pay themselves a salary, pay back some supplier debt and look to grow the business again … until it once again reaches a point where the funds available are not enough and they run out of cash again. This happens because as a business grows, the working capital required to operate the business at the new level also grows.

Other businesses have positive cash gaps, which may create opportunities for a business owner.  This is called a “float”.  The float refers to the gap in time in which you are paid by a customer yet don’t pay the vendors for a good or service.  You are essentially getting interest-free financing from your vendor in this situation.

All of this must be managed.  There are ways to influence DSO, DSI, and DPO.  A smart business owner and their accountant will work with operations to manage this as part of the overall cash conversation cycle.  Creating a significant float can give a business owner flexibility and give them the chance to implement a strategy to use this “float”.  Most importantly however, managing the cash gap will help small business owners maximize working capital and avoid cash flow issues.

My name is Matt Krieger, and I am the founder of Krieger Analytics, a CFO advisory partner for small businesses and franchisors.  I am also the owner and franchisor of a concept called Monkey Bizness, in Denver, Colorado. 

As a small business owner with a background in finance and strategy, I realized the benefits that a CFO could bring to smaller organizations.  Most franchisors and small business owners don’t have a need (or budget) for a full-time CFO.  To better fit my clients, Krieger Analytics is a part-time resource.  While most think of CFO’s being involved in finance and accounting (we are), I am also involved in much more.  I partner with my clients by coaching them on strategy, gaining clarity on their business, building efficient and effective processes, and making confident business decisions.  Conversations are free, so don’t hesitate to reach out to me at [email protected].