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Cash Gap? If you're like many business owners you may not know what this is or even what its used for. Businesses fail because business owners don't understand that the cash gap is used to help calculate the working capital requirements of their business. It is the time between cash going out and cash coming back into the business. To calculate it add your inventory days to your accounts receivable days, then subtract your accounts payable days. Ignoring this number can quickly sink a company. Simply put, you want this number to be as small as possible. The smaller it is, the less money it takes to fill the gap. I like to call this the "driving gear" of your business. You want it to be small and move fast. To learn more about the Speed of Cash and how all the components work together use the resources located at CashFlowTool.com.
This is the biggest unanswered question in small business. Of course, it can be a different answer for every company, but the standard rule of thumb is 3-6 months of operating expenses. Ultimately, you have to determine what your comfort level is because 6 might be too much and 3 months might make you uncomfortable. The one thing we can all agree on though is that you should always strive to have 45 days or more cash on hand. A few things to consider is how much you need to cover any seasonality? You might need more cash on hand if your trying to grow or expecting rapid growth soon, like a big order. Also, don’t forget to plan for losing a few of your best customers. Any of these situations could put the business in a surprise cash flow problem. On the other hand, is the notion of a abundance/war chest. This is usually the amount of money mature companies have to take advantage of threats to the business, like a hurricane, or take advantage of opportunities, like buying out a competitor. Typically, you have an abundance/war chest if you have 18-24 months of operating expense set aside to deploy. The key thing to remember here is find a number between 3-6 months that you’re comfortable with to maintain a cash healthy business.
In some instances, the Days Cash On Hand ratio is considered the “burn rate”. Days cash on hand tells you how long you can continue to pay your operating expenses with the cash you have available. To make it more powerful to me, I called it Days to Bankruptcy. It is calculated by dividing the cash you have on hand by the amount of cash you spend on expenses on a daily basis. It works best to give you an idea of how much time you have left without making any other changes in the following situations. You are a start-up and don’t have a lot of sales yet. You are heading into the low part of a seasonal sales cycle need to stay open through it. Or, you are in a transition to a new line of business and are seeing declining sales in the old line. In the Speed of Cash concept, this is the “driven gear” of the business as a cash machine. You want this number to be as large and move a slow as possible. Higher numbers are best here. A good target is 45 days or more cash on hand.
This is a great question!! The most simple answer is speed. You want to control the speed that money comes into the company and how it leaves the company. The goal is to have money come into the company faster than it leaves. To do this, you have to understand the “levers” a manager has at his disposal to control the speed. For a company that has inventory, you want to have the right amount of inventory (enough to sell through quickly), collect from your customers at an acceptable rate (without waiting forever), and pay your vendors appropriately (not too fast that it hurts your cash position). These three variables are used to balance the flow of cash through the company. In a service based business, you don’t have the same issue with inventory. However, you do have to pay your employees. Therefore, you have to control the speed that your customers pay you, so you can pay your employees. There are mathematical equations to help you understand how much money you need to maintain the balance. Just remember that the goal is to keep cash in your company as long as possible.
I like to call this “Days to Bankruptcy”. The most important thing to remember about this ratio is that it assumes that you will have little or no sales. It doesn’t take into consideration that you have an active business with a fluid revenue and expense stream. This could be used as a quick gauge of how much cash you have available. This number should be over 45 days to give you a buffer in case of unexpected changes in your business. Another scenario is for those businesses that experience seasonality. If you know that your business takes a dip in sales at different times of the year, you can use Days Cash On Hand to help make sure that you can cover your expenses through the down cycle. If your down cycle is 60 days, then plan to have that much cash on hand. The last point I would make is not a very cheerful one. This number can also help plan your “wind down” timeline if you are planning to close your business.
Working capital is also known as “the cushion” you have in your company. You almost always want this to be a positive number - known as a positive working capital position. Your current assets and your current liabilities on the balance sheet are assumed to be sources and uses of cash to run your day-to-day operation. Having a positive number here shows that your business generates enough cash to sustain its own daily routine. Banks will look at this closely because it shows that you are generating cash through your operating activities – which is highly preferred over getting cash from selling your assets.
This is the one ratio that can get a little confusing, especially if it doesn’t seem to align with your Days Cash On Hand number. As opposed to the Days Cash On Hand, the Cash Shortage number is measuring the cash conversion cycle of your business. Also known as the Speed of Cash. The goal here is to have enough money to fund new orders, while you’re waiting on payments from previous sales. This amount is generally used to answer the first question a banker will ask if you apply for a line of credit. Your line is designed to fund your conversion cycle by giving you enough money to pay your expenses through your financial gap days. The financial gap is the amount of time you are waiting for your customers to pay, after you paid your bills. Your company still needs money to fill orders as they come in. Use this cash shortage number as the amount of money you would ask for when making a loan request. It can also serve as a gauge of how much additional money you should keep in the company prior to making any distributions to shareholders.
CashFlowTool pulls transactional data directly from QuickBooks Desktop or QuickBooks Online. If your bank accounts are connected to QuickBooks, then all of your reconciled bank transactions will be shown.