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FOOD FOR THOUGHT

How to calculate working capital and your cash gap

Posted by Mike Atkinson on May 21, 2015

Despite their best efforts, many businesses struggle to shake off their cash flow restrictions. Why? Mike Atkinson explains. 

 

How to calculate working capital and find your cash gapNow

 

The 'cash gap' is the time between cash going out and cash coming back into a business. Nearly evey business has one, but left unchecked it can turn a profitable job or project into a financial mess. The root of the problem is that many business owners don't know what their 'cash gap' is, or how to calculate their business' working capital requirements. 

 

How to calculate your 'cash gap' 

Let's assume we run a business with stock (although the same principals apply to service businesses). We buy our stock on day 0. Let's assume that our stock sits on the shelves for 60 days before it is sold. Unfortunately the stock that we purchased has to be paid for and was on terms of 30 days. The stock finally sells on the 60th day, but our terms of trade entitle the customer 30 days to pay. However, times are tough and they pay late by another 20 days, pushing our total Accounts Receivables period to 50 days.

 

  1. You purchase inventory (accounts payable increases)
  2. You pay for inventory (cash out)
  3. You make sales (accounts receivable increases)
  4. You receive payment (cash in)

The final bar (in red) above represents our 'cash gap'. It is the numbers of days between when you paid cash and when you received cash, in this case 110 days minus 30 days, which is a 'cash gap' of 80 days.

 

How to calculate working capital required to fund your 'cash gap'

The 80 day cash gap in the example above has to be funded somehow. Typically this is done via a bank overdraft or by injecting shareholder funds. Let's take our example a step further and assume that we have a business which has annual sales of $3m.

 

Therefore our daily sales are $8,219 ($3m/365 days). If we generate a gross profit margin of say 25 percent then this would imply that our costs of sales are 75 percent of sales. On a daily basis our cost of sales would therefore be $6,164. Now here is the kicker. With a cash gap of 80 days, we need to fund 80 times $6,164. This implies that our working capital requirements would be $493,150, which could be a problem if our bank overdraft is only $300,000.

 

Extending your loan or requesting an overdraft only works for so long. 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. 

 

A business may increase the time it takes to pay creditors, but this is often only a short term solution and can negatively impact on potential discounts or favourable terms offered by a supplier. We would suggest that a business should first focus on shortening the time it takes to collect cash from debtors and restructure inventory turnover. 

 


 

To find out more ways to control the cash gap, plus strategies that can help speed up your working capital cycle, contact Mike.

 

 

 

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Topics: Cash Flow