Cash gap: find it, fix it
A cash gap is a result of the imbalance of inflow and outflow of cash in the company.
Increase in receivables, unreasonable credits to customers and large expenses, the owner suddenly withdrawing his capital, seasonal fluctuations of the business — all these can be the causes of cash gaps. A shortage of money occurs at the worst possible time — when you need to pay employees, contractual counterparties, or taxes. Ultimately, the company fails to fulfill its obligations and liabilities, which leads to reputational and financial losses. It has to pile debts on debts, sell off property or be branded as a bad employer.
In an uncertain economy, the risks of such gaps increase significantly. For example, during the COVID-19 pandemic, many once-successful companies faced it for the first time. So, is it possible to predict cash gaps, how to prevent them and what to do if it did happen?
Cash gap formula
Such a tool as a payment schedule is used to predict risks, which is available in any cutting-edge management accounting system, including the Finoko service. Of course, you can do it with available spreadsheet software, but such work takes a lot of time. And if you have a large number of transactions, the chance of human error rises significantly. Therefore, one cannot do without an automation system, even despite the fact that the calculation formula seems very simple.
The payment schedule is basically a visualization of a report of a cash flow forecast in a daily context. It indicates when, to whom and how much money has already been transferred and is expected to be transferred in the future. Debts are shown in the same way. Based on the company’s available funds, a cash flow forecast chart is built. The formula is simple А= В+С-D, where:
- A – cash balance at the end of the day;
- B – cash balance at the beginning of the day;
- C – takings;
- D – payment.
But, of course, the payment schedule is just a tool that shows how well the company’s financial policy is designed. It will help to more or less accurately estimate the period when the problems will likely occur, while ways to solve them, for example, to redistribute the budget and to manage the debtors, is up to managers.
The causes of cash gap
The main reason for the cash gaps is poor management, meaning the inefficient planning of cash flows. Besides the poor judgment of managers in predicting such risks, there are no backup plans if cash gaps occur. There are several completely different reasons for it. Here are some:
- Unprofitable business model. It often happens that a business seems successful on the outside and shows great turnover. However, in fact, if you look in detail, it runs at a loss. Let’s say that in a chain of stores, only a few make a profit. In the total volume of business, owners may not notice such an imbalance. In this case, cash gaps are almost inevitable.
- Payment prioritization mistakes. This is the case when the company has sufficient cash flows but does not distribute them correctly. First of all, minor expenses are paid, and then, there is no money left for the mandatory ones.
- Lack of control over cash flows. Many companies allow customers to set up a deferred payment agreement, and work with suppliers on an advance payment term. That said, the timing of the transfer of money can vary pretty much, and payments are received unpredictably, and this is already a risk.
- Mistakes in purchase volumes. An incorrectly calculated quantity of purchased goods can turn into “dead” money if a large batch has sat in a warehouse for a long time.
- Seasonal fluctuations. Companies with unstable cash flows are at risk here: government contractors, commercial tenders’ participants, and seasonal businesses. Under these conditions, it is difficult to plan inflows and outflows, which also increases the likelihood of cash flow gaps.
How to deal with the cash gap
There are several proactive ways to minimize the risk of cash gaps. We have already mentioned the payment schedule, which diagnoses the likelihood of an imbalance. An effective solution for introducing such a schedule can be the Finoko management accounting automation service, which will help you control the financial flows of your company. In addition, there are several other methods:
- Registration of requisition to pay. You can only manage what you can count. And the first thing to do is to introduce the practice of registering all requisitions to pay. Requisitions to pay can be created automatically, at the facilities or made by employees in the office; the main thing is to control all planned payments, and the sooner they are registered, the more convenient it is to manage them.
- Better debtor management. The introduction of clear regulations for managing debts simplifies the company’s life. These regulations may include payment schedules, late fees, legal methods of influencing debtors, and more.
- Payment prioritization. Divide all payments into mandatory and standing ones, such as rent, taxes, utilities, and recurring payments that you can postpone if there is a risk of a cash gap. To prioritize payments, use the payment schedule.
- Drive sales and optimize inventory. Sometimes, you can arrange sales with discounts if products just sit in storage in warehouses. However, it is better to remember that such a decision will reduce your future income. It also makes sense to identify products that bring minimal profit and, possibly, delete them from the portfolio.
- Management accounting automation. It is often the case in business, that there is money in the accounts, but it is not yours: you received an advance payment on the project, and it is not time to pay off debts to suppliers. If a company uses a cash-basis method of recording accounting transactions, then business owners and managers crave to invest in new lines of business, fixed assets or withdraw some money from the business. Investments in development and payment of dividends are indicators of a well-functioning business. It is important to correctly calculate the amount of profit that the business is ready to part with at the moment. It is impossible to do this using only the cash-basis method — it is necessary to consider all assets and liabilities at the time of their occurrence. The income statement and the managerial balance sheet will help to calculate the profit that can be paid out as dividends.
- Due diligence check. The questionable integrity of your counterparties may pretty much result in non-payments, which means extra risk.
How to bridge the cash gap?
So, what to do if extraordinary events occurred, proactive methods did not work, or the company simply did not have a plan, and, as a result, the cash gap caught it up? It is for sure that you need to find money as soon as possible, and, as far as feasible, postpone current payments. Here are some tips on how to do so:
- Partners and clients. Agree on a rent delay or delay in payment with contractual counterparties who supply you with goods. Here, even a short pause can be life-saving. If there is a risk of a long cash gap, then payments will have to be prioritized according to the least-evil solution. Those of them that will bring the least damage can be postponed. Naturally, absolutely optional payments, such as entertainment expenses, are postponed first. At the same time, it is necessary to step up efforts on collecting receivables — up to judicial order.
- Owners, shareholders, property. In case of cash gaps, the owners of the company can help with their dividends. The company can also rent out some property or equipment. Another way, more suitable for large businesses, is to sell a block of shares or issue additional securities. However, in this case, there are risks of losing control over the companies.
- External financing. It is the most unwelcome and, perhaps, the most challenging option for a company in a difficult financial situation. It is unlikely that banks will cheerfully give a loan to a business that has obvious problems. Getting a loan quickly, and, moreover, with a good interest rate, is almost unrealistic. But there are other, more affordable financial instruments: overdraft and factoring. Banks allow some clients to go negative for a certain amount (overdraft), and, in the second case, we are actually talking about the sale of receivables at a certain discount.
In 2022, the most popular ways for businesses to close gaps were: payment deferment to suppliers, investing own funds and speeding up the collection of receivables.