Updated February 06, 2001
The cash gap refers to the time interval between the date when a company pays cash out for the inventory it purchases and the date it receives cash from customers for the same inventory. Naturally, all companies would like to have customers pay for the goods before the suppliers demand payment for the goods. However, most companies are not this lucky.
Three factors impact the cash gap: the payables period, the receivables period, and the days in inventory.
I show 365 days per year, but some accountants use 360 days to simplify the calculations.
Average Daily Sales = Annual Sales / 365, or
Average Daily Sales = Monthly Sales / 30
Average Daily Purchases = Annual Purchases / 365, or
Average Daily Purchases = Monthly Purchases / 30
Inventory Turnover = Cost of Goods Sold / Ending Inventory
Raw Materials Turnover = Cost of Materials Used / Ending Materials Inventory
WIP Turnover = Cost of Goods Manufactured / Ending WIP Inventory
Number of Days in Inventory = 365 / Inventory Turnover
Number of Days in Receivables=Receivables / Average Daily Sales
Number of Days in Payables=Payables / Average Daily Purchases
In this first example, a company turns its inventory six times per year, pays for its inventory in 40 days, collects its receivables in 50 days, and earns a 30% margin on its sales. That is, sales minus the cost of the inventory sold equals 30% of dollar sales. Average daily sales equal $10,000. The following graph visually depicts these relationships.
To compute the amount of cash the company must borrow:
The company pays for its inventory 40 days after it arrives, keeps it another 20 days before selling it, and collects 50 days after that. Thus, the company must cover 70 days of sales by borrowing from the bank. This amounts to 70 x $10,000 x (1-.30), or $490,000.
The second example is exactly the same as the first, but the company turns over its inventory 18 times per year instead of only six times per year. Such high turnover levels are common in companies using just-in-time approaches to inventory management.
Graphically the new situation looks like this.
Notice how the company has only twenty days of inventory on hand in contrast to the 60 days of inventory it had in the first example. This reduction in inventory means the company now sells the inventory 20 days before it pays for the inventory. As a result, the cash gap drops from seventy days in first example to only 30 days in this example.
This requires the company to borrow only $210,000 in contrast to the $490,000 in the first example. At an interest rate of 10% the company would increase profits by $28,000 per year with the faster inventory turnover. Check out this calculation for yourself.
In cases where sales grow rapidly and the cash gap is large a company can quickly run out of cash. To help assess the ability of a company to sustain sales growth rates over sustained periods, I have created the following spreadsheet to show the cash effects of various growth rates when a firm has a given inventory level, collection period, payables period, and margin percentage.
To download a copy of this spreadsheet, just click here for the Excel spreadsheet.