The cash flow gap is a very real problem for Australian businesses. For businesses providing goods and services on credit terms, the accounts receivable period makes this problematic cash flow gap even more of a problem!
We explain the cash flow gap and outline ways to reduce them both for your business clients.
What is a cash flow gap?
The cash flow gap refers to the time interval between the date when a business pays cash for inventory or wages, and the date it receives cash from customers for the same inventory and services rendered. The larger this interval, the greater the cash flow gap in a business.
Consider a retail business. They pay cash for an item of inventory (let’s say it’s a couch) on the 1st of September. They sell the couch on the 10th of September and receive cash from the customer on that same day. This business’s cash flow gap is 10 days.
Now consider a wholesaler. They purchase goods and pay cash upfront on the 1st of September. 20 days later, they then sell these goods to their customer on credit terms of 30 days. The customer takes the full 30 days to pay the invoice, meaning the wholesaler receives the cash on 9th November — a whole 50 days after outlying cash for the inventory.
As you can see, the nature of particular industries can influence the length of the cash gap. A cash gap exists for businesses that receive cash at the point of sale, but the accounts receivable days arising from providing goods and services on credit terms push cash gaps out even further.
How can you identify a cash gap in a business?
Determining a cash gap involves three different financial measurements: the receivables period, days in inventory, and the payables period.
The key to managing the cash gap is to reduce the receivables period and days in inventory and/or increase the payables period. In other words, the business will want to turn over inventory quickly to access cash, while delaying payment to suppliers if possible.
Some of the biggest and most frequent contributors to cash flow gaps include the accumulation of excess inventory and materials, poor collection efforts, delayed invoicing of customers, and accepting short payment terms with vendors.
Reduce the receivables period
The receivables period is the average amount of time taken to receive payment for invoices issued.
To get cash in the door faster and reduce the receivables period, there are a number of steps a business can take:
- Creating clear terms of payment and placing an emphasis on them whenever the business takes on a new client.
- Making sure the invoice due dates are clearly marked so there’s no opportunity for clients to claim they didn’t know the invoice was due.
- Issuing invoices in a timely manner (ideally, as soon as possible). The longer the business waits to issue them, the longer they’ll wait to receive payment.
- Ensuring the accounts department is ultra-responsive, chasing up payments as soon as they extend beyond the agreed-upon terms.
- Offering a number of payment options (though be wary of those that may cause further delays in payments reaching the account).
- Offering a discount for early payments (though the benefits of getting the money early must justify the discount offered).
- Make paying as easy as possible by offering a number of different options, including accepting credit cards or online methods of payment.
- Establish a deposit policy for works in progress, especially for new customers or long-term projects.
- Charge a late fee for payments after a certain date.
Improving inventory control
If a business sells physical products, they naturally have to invest in inventory before they can sell it. But how much time passes between these two events? The bigger the cash flow gap between buying and selling inventory, the more likely a business is to experience cash flow issues.
Moving toward a “just-in-time” inventory system (producing inventory to fulfill orders rather than accumulating stock) could help to reduce the number of days inventory sits around before being sold.
Drop shipping is a sales model that basically has no cash flow gap. Or even a negative cash gap. Customers purchase goods online, the goods are then sent out to them from a location independent of the business owner. For example, a business that sells t-shirts under a drop shipping model could sell a t-shirt via their website, but the inventory is owned and held externally to their business. The business owner hasn’t had to pay for the t-shirt until they’ve already received the cash from the customer — zero cash gap! If the t-shirt manufacturer was charging the business via an invoice at the end of each month based on t-shirts sold, the business owner would have received the cash for t-shirts sold before having to outlay any cash for the inventory — a negative cash gap!
If a business sells various different products, it could be wise for them to concentrate on fast-moving inventory to turn over inventory more quickly.
Lengthen the payables period
The payables period is the average number of days it takes a business to pay its suppliers (or accounts payable). Extending the payables period means the business has a longer period of time to be able to sell their goods and receive payment, before payment to their suppliers are due. Lengthening the payables period can significantly reduce the cash flow gap (or even eliminate it all together).
Ways to extend the payables period:
- Negotiate longer payment terms with suppliers.
- Prioritise bills by due date and pay each one as close to the due date as possible.
- Re-negotiate payment arrangements if necessary.
Monitor business growth
If your business client is experiencing rapid growth, they’re particularly vulnerable to experiencing a cash flow gap that can have significant consequences. The key risk for a business in this position is a deficit of cash flow and working capital.
It's also important to keep an eye on fixed costs as the business grows. If they’re expending a lot of energy buying stock and hiring new employees but not keeping an eye on collecting cash, they may run out of money to continue trading.
Finance to plug cash flow gaps
The reality for businesses that offer credit terms is that most customers will utilise these terms to their full extent — with many even paying later.
If a business has implemented all the steps above and they’re still experiencing cash flow gaps, it may be time to consider a business finance solution.
At Earlypay, we offer Invoice Finance, a credit facility that grants businesses access to cash from unpaid invoices. Invoice Finance can significantly reduce the payables period (effectively reducing the cash flow gap) — an invoice is issued, and the business can access funds immediately.
If you’d like to learn more about how you can help your clients analyse their financial statements to identify areas that could reduce their cash flow gap, please get in touch with your BDM or contact [email protected] — we’d love to demonstrate how Invoice Finance and other tactics can help.
If you'd like to learn how Earlypay's Invoice Finance & Equipment Finance can help you boost your working capital to fund growth or keep on top of day-to-day operations of your business, contact Earlypay's helpful team today on 1300 760 205, visit our sign-up form or contact [email protected].