It takes money to make money.

About three weeks ago, I was sitting with my children discussing their latest idea to start a kids’ business. They have this notion of making oatmeal cookies to sell to make some money to buy a game console that they have been eyeing. While the cookies are rather tasty, and I love their enthusiasm for trying to come with an idea to get the console without resorting to begging, I had them lay out their concept and how they would accomplish their goals. Like many entrepreneurs, they had a product, they had the start-up funds, but they didn’t think of all the additional costs to get the product to their market. They wanted to mail the cookies to friends and family, this concept led me to tell them about shipping costs. While this is a simple issue to fix by adding additional cost to the cookies’ final price it showed them that “It takes money to make money.”

In Roger’s, Entrepreneurial Finance, he states that businesses can fail from not having cash to cover costs while a business wait for customers to pay for products or services.  One of the main reasons for a lack of cash is caused by the Cash Gap (Rogers, 2020, pp. 123-127). The Cash Gap is caused by a period from when the business spends money on resources until the customer pays for the final product. The way that this gap affects the business is that having inventory or customers owing you money does not pay for the utilities or wages for laborers.

To better understand the Cash Gap lets investigate the factors of the Cash Gap. The three factors that cause the Cash Gap are; DAYS PAYABLE, INVENTORY DAYS, and DAYS RECEIVABLE.

Days payable is the amount of time that the supplier gives your business to pay for your resources to sell to your customer.

Inventory time is the amount of time your products sit on a shelf waiting to be sold. If your business produces the final product, the inventory time before production should be investigated to determine if it needs to be added to the inventory days.

Days receivable is the amount of time that your product is no longer in your possession, yet you have not been paid yet.

The Cash Gap can be calculated by the following formula;

Inventory days + Days receivable – Days payable = the Total Cash Gap.

To increase cash to pay for business needs, the business should be looking into how to lower the Cash Gap. By increasing or decreasing the days for each of the three factors of the Cash Gap, a business can have more cash on hand.

Days payable; can be altered by paying for supplies at the maximum amount authorized by your supplier. Talking with your supplier to extend your timeline to add day can be viewed in the same way as getting a no-interest loan on supplies. Remember that as you are trying to keep you Cash Gap as small as possible your supplier will be looking to do the same, so work with them and not against them.

Inventory days; can be reduced by ordering what only what you need. Having bench stock a good practice to ensure that you don’t run out of supplies when trying to fulfill product orders, however, having too much can tie up funds during this period that will not be turned into profit until the next period. Businesses in retail know that not having product on the shelf means that when customers are looking for the product and leave your establishment that is money walking out of the door. By managing an inventory accounting process will allow the business to have the product on hand without having too much in the stockroom.

Days receivable; is the hardest thing to manage because you cannot always make a customer pay for products and services rendered when the bill is posted. While this factor is the hardest to control, there are things in which a prudent business can do to limit the waiting period. Before opening lines of credit from your business know the business history. Asking for references and look at their history of how well they pay will keep you from going into a business relationship blind. If a business doesn’t have a track record that meets your standard, your business can investigate other options such as; partial payments upfront, cash on delivery, or be paid in full before they take possession of the product.

By lowering inventory days and days receivable and gaining additional time on days payable a business can lower their Cash Gap and not only have funds for more resources but have the funds to pay the employees that keep the business going.

Source:

Rogers, S. (2020). Entrepreneurial Finance, Fourth Edition: Finance and Business Strategies for the Serious Entrepreneur (4th ed.). McGraw-Hill Education.

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