A cash gap is a situation where an entrepreneur simply does not have enough money to fund their financial obligations.
The pandemic and lockdown led to many businesses losing their revenue – beauty salons, restaurants, hotels, cinemas, travel agencies. Whereas, their mandatory expenditure such as taxes, salaries, insurance premiums, and loans were not discontinued. They have no money, yet, there are payments to be made. Cash gaps have led to massive bankruptcies.
50% of entrepreneurs experience such problems even under normal circumstances. Every business owner needs to learn how to prevent cash gaps, and predict them in advance. This is a whole lot cheaper and easier than trying to solve cash gap problems when they arise. Unless of course, you’re a hell of a loan fan.
7 causes of cash gap
1. The business is unprofitable, but the owner does not realize it.
Teresa Sheppard, a Financial management and Tax security expert comments:
“My client in Manchester has 17 pharmacy outlets and a constant shortage of funds. And for the nth time, he was receiving a products credit from his suppliers. Included in the goods credit are goods no one needs, as well as fast-selling goods. So, we decided to analyze the profitability of each of the shops with the owner. It turned out that out of 17 outlets, only 2 were profitable. The owner did not keep financial records, so he did not understand how huge the losses were. This is why my advice is to analyze every area, project, and outlet of your business carefully, and evaluate its profitability. If any of them is running at a loss, you need to get rid of it or work out a way to make it profitable.
How to avoid a cash gap:
Keep financial records and analyze the profitability of each business venture (project). If the business owner had evaluated the profitability of each outlet, he would have seen that the business wasn’t profitable, he would have identified weaknesses, and possibly closed down the cash draining outlets to prevent cash gaps.
2. Lack of planning
Simon decided to go into the advertising business. He rented an office, hired employees, and attracted customers. Revenue grew, and he received large orders from big companies. In order to deliver on the orders, he massively increased staff strength. On the 5th, which was payday, Simon realized that there was simply not enough money in the accounts. A postpaid contract had been signed for two large projects which were supposed to bring in huge income. Payment would only be received in a month’s time. The owner had to borrow money from friends to meet up with salaries, which were still delayed.
How to avoid this:
Plan your budget or use a bill payment calendar. Enter the predicted cash movements. If in a certain month, the account balance is less than the expenses, then a cash gap will occur. You then need to think about how to avoid the cash gap, where to get funds on time, or how to reduce expenses.
If Simon had written out all expected income and expenditure, he would have seen when a cash gap was bound to occur and taken precautionary measures in advance. He would have made arrangements for a big client to make an advance payment.
3. Large accounts receivable
Mark, the owner of a window installation company, launched an advertising campaign with an interest-free installment plan. He made an offer to his clients to pay 50% of the cost of the windows before installation, and the balance within three months. Most of the clients fulfilled their obligations, but some refused to pay, citing a difficult financial situation. Mark started calling debtors regularly, but sooner or later, they stopped taking his calls. The legal consultant informed Mark that the contract had been drawn up with serious errors and that there was no point in going to court. The loss from non-payments forced the business owner to go into debt.
How to avoid this:
Teresa Sheppard:
“Each company should have regulations on working with accounts receivables and have an employee who assigned to this task. The employee in charge of accounts receivable should always have a clear understanding of when the debt becomes overdue. In my practice, there was an instance where a company had an incompetent financial director, and in a bid to compensate for the shortage of funds, he took out loans. Loans always come with interest. No employee was assigned to work with accounts receivable, the company lost $ 30,000 a month, and also had loans to repay. Don’t do this! Work with accounts receivable”
4. Overstocking
Laura has a toy and children’s goods store. Before the New Year, her supplier offered her a huge discount on a large batch of Christmas decorations. Laura thought that she would be able to sell all the goods on time, but a competitor’s store opened nearby and demand was lower than expected. After the holidays, a third of the products were still in stock. There wasn’t enough money to pay employee salaries. The business owner had to sell the products at a huge discount, much lower than the purchase price, in order to sort out debts.
How to avoid this:
Overstocking at any point is a loss for business. While the product is in stock, it does not bring any money, instead, it does the opposite. After all, you spend money on renting storage. If the market is not experiencing major spikes, you can avoid overstocking with the help of competent inventory management and purchase planning. Analysis of the product range will show which items are in demand, which are bought less often, and in what quantities. Knowing the locations from which you get the most orders, calculating optimal purchase volume, and good marketing will help you avoid freezing funds.
For goods and materials, you also need to put turnover and marginality. into consideration. For products, all unwanted items stored in the warehouse should be gotten rid of – they are frozen money.
5. Unrecorded investments in equipment, office, and transport
Tom decided it was time to expand his business and to acquire a warehouse. There was money in the account, the price was very attractive, the location was suitable – a great investment! But The CFO stopped him. The investment only seemed tempting at first glance: the funds in the account were already planned out. Part of the amount will be transferred to suppliers in the nearest future, another part will be used for an advance tax payment. All that remains would be the financial reserve. Renting this warehouse would be feasible for the company.
How to avoid this:
Every investment needs careful analysis. If you as the business owner cannot determine the effectiveness of such investment by yourself, it is better to consult a financial expert. This will help you calculate all possible options and make an informed decision.
6. External factors
This can include a pandemic, sanctions, long holidays, and new laws.
Retailers are also affected by these factors. Christy owns a small shoe store and didn’t have time to label the product on time. After inspection, a fine was imposed on her and shoes without labels were confiscated. These accounted for about a third of the total volume. Due to the reduction in the assortment of shoes, sales fell, profit was less than planned, and there was a cash gap.
How to avoid this:
No organization can insure itself against this. But you can think of a financial safety net-a reserve for unforeseen expenses.
7. The business owner has taken on too much
Brian is certain that a businessman should live in luxury. And there it was – an advert for a new car. Yes! and at a 20% discount too. He’s sure he has to make this purchase, especially since there was still enough money in the cash register. But soon after purchasing the car, and it arrives the warehouse, he needed to pay suppliers and employee salaries. He had to request for a delay or even take out a loan to close the cash gap.
How to avoid this:
Funds should be separated from profit. Money in your accounts is not profit. To find out how much money you can withdraw without putting the company in a compromising position, you need to look at the income statement. You can’t withdraw more than the amount of profit made for the period. Also, be sure to plan income and disbursements, so you will know if there is a risk of a cash gap in the future, after the withdrawal of funds.
What should I do if a cash gap occurs?
1. Perform a cost analysis
When in a hurry, you can make a lot of mistakes: turn down purchase opportunities, dramatically reduce advertising costs, lay off valuable personnel, and sell goods below cost price.
Look at the financial statements. How much do you owe suppliers? What payments need to be made – loan, taxes, payroll? Is it possible to reduce expenditure?
From your planned expenses, you need to select the most urgent ones and pay them first. It is better to delay payments with low priority, at least for a while.
2. Come to an agreement with Counterparties
If it is possible for you to arrange an installment payment plan or carry over payments, you should use it. Have you been paying rent regularly for 5 years? Talk to your landlord, and I’m sure they’ll be willing to make some concessions.
3. Collect accounts receivable
Do you have an assigned employee who works with debtors? Are you sure that you can’t collect any more accounts receivable? It’s time to make the most of this process.
4. Convert liabilities into assets
The organization may have buildings, equipment, or space that are not being used. They can be rented out or sold. Before selling, you need to calculate all the risks: how often they are needed? how much will it cost to rent from third parties if necessary, and will the company will lose its competitive advantages?
5. Invest your money
Business owners can use their resources to avoid cash gaps. But if you constantly need to use your money to patch up budget holes, then, there is work inefficiency. There is another extreme, when money is taken out of the business uncontrolled, and the gap is closed with loans. The way out of this situation is to separate financial flows into personal and business.
6. Take out a loan
This idea is sometimes beneficial – borrow now, and pay back immediately after you get funds! You don’t even have to pay interest!
This method can be called effective if cash gaps rarely occur, the company is confident of receiving money, and the owner or manager has strict principles to return the loan on time. But sometimes the company receives money and it is immediately spent on urgent needs. The loan payment is delayed, the monthly interest seems small compared to the full loan amount, and in the end, the interest culmination turns out to be significant.
7. Use an overdraft card
An overdraft is a loan to a company’s account. If a business is faced with a lack of funds, it can get them from the bank, without getting a loan. They only need to “run a negative account”. And all payments made into the account will pay off the debt. This can be an excellent insurance policy in unexpected situations.
8. Consider factoring
Factoring is suitable for postpaid transactions. First, the company delivers the goods to the buyer, then assigns the right of claim to the factor. The factor transfers part of the company’s money. The buyer doesn’t pay to the supplier’s company, but to the factor. The initial payment amount and commission are deducted from these funds, and transferred to the supplier company. What is the benefit? The company immediately receives money and some of the functions of controlling accounts receivable are transferred to the factor.
Rob Bulloch, Head of Customer Relations:
“The principle of overdraft and factoring are similar: they can be used at the same time when funds are needed and in the amount that is needed. The difference is that an overdraft carries with it the need to maintain turnover in a particular bank, which is not always convenient.
When you use factoring, there are no such requirements. It allows you to sell your payment obligations to the factor and immediately receive funds, regardless of the turnover of previous months.
We, like other financial companies, may have cash gaps. To avoid this problem, we adhere to a financial model in which the cash reserve is several times higher than the planned cost of repurchasing customer accounts receivable. We adjust this model on a quarterly basis”
Expert opinion
Christine Sloan, PhD Economics, MBA:
“How can you avoid a cash gap?
Step 1. Evaluate the actual position of your business based on key indicators for the current day.
Step 2. “Scan” all your documentation. Perhaps there are some contracts worth reconsidering? Prepare all you need for WIN-WIN negotiations. And for the future, it is better to make provisions for the possibility of deferred payments.
Step 3. Ask customers to make a prepayment or an advance payment.
Step 4. Plan your income and expenditure. A monthly payment calendar with a daily record of each step will help you do this.
Step 5. Think about your debtors and creditors.
Do not waste time getting money from debtors and using it for the benefit of the business. Review loan agreements for changes in bank terms and conditions and find an opportunity to renegotiate business. Take the new interest into account in the cost price.
Step 6. Look for additional financing.
And remember that you will also have to pay something for this later. It so happens that it is more profitable to give up your company and rather than multiply debts “
Brian Galm, CEO:
“I recommend that you pay attention to 5 key rules that allow you to minimize the risks of cash gaps:
- Set up financial planning and maintain a payment calendar.
- Control the time interval from the moment goods or materials are purchased and their arrival in the warehouse, and until payment is received from customers. The shorter the operating cycle, the more frequent deliveries and more profit.
- Keep track of how quickly the money invested in the business turns into profit. The longer the financial cycle, the more money the company needs to run smoothly.
- Define your payment policy. Ideally, you can get your customers to agree to prepayments (in return, you can offer a discount for early payment), and agree with your suppliers for you to make deferred payment. Make sure that the time frame within which you need to make payments to suppliers is longer than the deferral time frame that you provide to customers.
- Remind debtors of the need to pay off their debts on time – this is a good preventive measure for timely replenishment of working capital”
Proper accounting of finances will save the business from a lack of funds in the cash register, shows the profitability of the business and individual departments. Start by planning your income and expenditure.
