How do cash flow gaps affect cash management?

December 15, 2021
clock
2 mins
Timing of cash in versus cash out can lead to financial precarity for small businesses. Learn why cash flow gaps happen, and how to address them.

What exactly is a cash flow gap?

Before a business can create a product or develop a service, its leaders need to invest in the people and processes that bring ideas to life. But that means that from day one, there’s a cash flow gap — and that gap is core to why every business grapples with cash flow.

So why is the cash flow gap important, and how does it hinder companies’ stability and ambitions?

How does cash flow work?

First, consider that cash flow consists of two primary flows — money goes out, and money comes in. The pattern repeats over and over throughout the year, and is often referred to as the cash conversion cycle. Cash out includes anything from rent to payroll to phone and internet bills to daily expenses to accounts payable — and any components of cost of goods sold. Cash in could be at a point of sale via cash or credit card, or it could be part of an accounts receivable process, in which companies extend credit to their customers for a defined period of time.

There’s a timing issue for businesses whose cash inflows trail cash outflows — i.e., all businesses. Businesses must spend ahead of any cash they can receive. The earlier payables and expenses are paid, and the later customer payments and receivables come in, the wider the cash flow gap. When businesses collect customer payments late, or extend customers more generous terms, the cash flow gap (or cash conversion cycle) is extended, especially if spending continues as usual to maintain consistency of staffing, services and output.

Managing the timing of inflows and outflows represents a delicate balance for smaller businesses, which often are nurturing relationships with suppliers and customers, and might lack the scale of larger enterprises to set terms.

What happens when businesses don’t manage cash flow well?

What are the consequences of failing to manage cash flow and the cash conversion cycle? And what should businesses consider doing to improve their processes around it?

When an unexpected rocky patch, a larger-than-anticipated seasonal lull or a substantial late payment from a major customer slows inflows, the cash flow gap increases. A business needs capital on its balance sheet to continue operating without disruption; other options to bridge gaps can come at a high cost. Without sufficient cash reserves, businesses can tap into a line of credit, but if a line of credit is not established they might seek short-term loans that often come with high interest rates. Creating such a liability means that future customer payments go toward satisfying debt obligations — rather than being invested back into the business.

Solving for cash flow gaps

By contrast, the shorter the cash conversion cycle — the smaller the cash flow gap — the faster businesses turn money spent into money earned. Cash can be put to use; for example, excess capital can go toward adding inventory, opening new locations, or investing in resources or equipment to expand and grow.

Speeding up receivables by shortening credit terms or offering discounts for early payment is one way to minimize the cash flow gap. Examining and actively managing payables is another. Understanding how best to apply for and make use of credit is a third key component. When used wisely, credit allows businesses to hold on to cash while meeting their payables responsibilities — giving them additional more time to collect revenues from sales to pay back the borrowed funds.

Every industry and each business is different — not all extend credit to suppliers or have significant accounts payable. But all businesses have a cash flow gap. Leaders who understand the specifics of their company’s cash flow holistically can then drill down into the areas and develop internal processes that positively affect the cash conversion cycle — and narrow the cash flow gap.

Get more insights, subscribe to our blog