Accounts receivable is often one of the biggest assets on a manufacturer’s balance sheet. But the faster you’re able to convert receivables to cash, the sooner you’re able to pay suppliers, employees and lenders — and the less likely you’ll be to draw on your line of credit to make up for working capital shortfalls.
Unfortunately, many of your customers may have gotten into the habit of extending payment terms during the recession. Now that the market has picked up, it’s time to retrain your customers to pay on time. The simple concept of the “cash gap” shows you the importance of minimizing accounts receivable.
Cash in vs. Cash Out
Calculating your company’s cash gap is simple: Add the average days in inventory to the average collection period for accounts receivable and subtract the average payment period for accounts payable.
For example, suppose ABC Co. stocks about 50 days’ inventory in its warehouse, collects its receivables in about 60 days and pays off its suppliers within 20 days. ABC’s cash gap would be 90 days (50 days in inventory + 60 days in receivables – 20 days in payables = 90 days).
Incremental Interest Costs
The cash gap reflects the timing difference between when companies order materials and pay suppliers and when they receive payment from their customers. This difference is frequently financed by a company’s line of credit. When funded by bank financing, the cash gap incurs incremental interest costs that can be easily quantified.
Getting back to our fictitious manufacturer, suppose ABC achieves a 60% gross margin on its $10 million in annual revenues, which equates to a $4 million annual cost of sales. ABC’s 90-day cash gap means that the company must front — and presumably finance — 90 days’ worth of its annual cost of sales, or roughly $986,000 [($4 million cost of sales ÷ 365 days) × 90 days].
If we assume a 5% interest rate on its line of credit — and ignore taxes — ABC’s cash gap costs the company about $49,000 each year in interest expense. For every day it shaves off its cash gap, ABC will improve its pretax profits by nearly $550 ($49,000 of interest divided by its 90-day cash gap). At higher interest rates, the incremental interest costs related to the cash gap are even more pronounced.
Eyes on Collections
There are few options to reduce the cash gap. You can cut back on inventory in your warehouse, but doing so may lead to shortages and eliminate bulk discounts. You can delay paying suppliers at the risk of losing early-bird discounts and receiving less favorable credit terms.
So speeding up collections is often the most effective and simplest way to lower the cash gap. Five ways to encourage customers to pay invoices include:
- Performing credit checks on prospective customers,
- Flagging new customers to ensure initial invoices are paid on time,
- Sending out past-due reminder letters or email messages and following up with phone calls,
- Offering “early-bird” discounts to customers that pay within 10 or 20 days, and
- Hiring dedicated, experienced collection personnel.
Manufacturers also should evaluate invoicing procedures to minimize the days in receivables. Poor communication among billing, sales and production staff can cause invoicing delays.
A Low-Risk Approach
But there’s no good reason to allow receivables to build up on your balance sheet — and no risk to expediting collections. So if you’re looking for a quick and simple way to shrink the cash gap, always start with receivables.