Managing the cash gap.

EXECUTIVE SUMMARY

* THE CASH GAP IS a simple concept that helps operating people understand how their actions affect a company's cash flow. It is easy to illustrate with a simple diagram.

* FOUR BARS ON A TIME LINE are all it takes to get the point across. The first represents days of inventory, the second the days of payables, the third the days of receivables, and the fourth--which is determined by the relationship between the first three--is the cash gap.

* INTEREST COSTS PER DAY OF CASH GAP can be calculated readily. For each day the cash gap is reduced, the daily interest cost saved flows through to pretax profits.

* THERE ARE ONLY THREE WAYS TO REDUCE the cash gap: increase the payables period; decrease the collections period; or increase inventory turnover. Tradition and the nature of the business often set the typical cash gap in a given industry. Some industries have inherently higher cash gaps than others.

* GROWING COMPANIES MUST MONITOR THE CASH GAP along with sales growth and profit margins, or they will encounter cash shortfalls.

How to help operating people use working capital wisely.

CPAs and other financial executives know how important effective cash management can be to a company's bottom line, but they sometimes have trouble convincing operating managers to pay sufficient attention to cash flow. Financial people need to make an effective case to win over the operating crew--even those who otherwise might be very good at managing sales, production, inventory or materials may need some persuading. The "cash gap" is a simple concept that does the job.

PICTURE IT

The cash gap is the number of days between a business's payment of cash for goods and services bought and the receipt of cash from its customers for goods or services sold. In other words, inventory days on hand + receivables collection period - accounts payable period = the cash gap. That interval must be financed. The longer the time difference, the more interest a company must pay. Even when interest rates are low, the cost of financing can add up quickly. When operating decision makers see this picture, they understand and can readily be persuaded to shorten that time span.

Although a desirable cash gap varies with economic sector, geography and season, the concept can be used to improve cash management at any company, no matter what the industry. Exhibit 1, part A, page 28, is a cash-gap diagram for the fictitious High Tech Widget Co. To draw the diagram, start with a time line in days.

[EXHIBIT 1 ILLUSTRATION OMITTED]

Assume that High Tech Widget turns inventory six times per year. In other words, it has about 60 days of inventory. This is calculated in the usual way--365 days divided by inventory turnover, with inventory turnover calculated as cost of sales divided by average inventory. Now look at the green bar in part A of exhibit 1. That depicts how long inventory is on hand. The green bar above the time line begins when the inventory arrives and ends when the inventory is shipped as product, in this case 60 days. Inventory activities always belong above the time line.

Next, consider High Tech's payables. Say it pays its accounts in 30 days, on average. The blue bar below the time line represents this. It starts on the day the inventory arrives (the left end of the green bar above the line) and ends on the day the check for the inventory leaves the company, in this case day 30.

Then look at the yellow bar representing receivables. Say High Tech collects its receivables in 60 days, on average. Below the time line, the yellow bar begins the day the inventory leaves the company (the right end of the green inventory bar, or day 60) and ends when cash is received from the customer.

The red bar, which is below the blue payables and yellow receivables bars, begins where the payables bar ends, and extends right to the point where the receivables bar ends. That red bar represents the cash gap, in this case, 90 days.

STRAIGHT TO THE BOTTOM LINE

The cash gap affects profits directly.

Imagine that High Tech Widget has a 40% gross margin on sales of $730 million per year. If it has to pay 8% on the money it borrows, each day of cash gap costs the company $96,000.

This is a straightforward calculation: Take the complement of the gross margin--the cost of goods sold--in this case, 100% - 40%, or 60%. The company has revenues of $2 million a day. The cost of goods sold for one day's revenues is 60% of $2.00 million, or $1.20 million. The cash gap is 90 days, so the company will have to borrow enough to cover 90 days' cost of goods sold, or 90 x $1.20 million, or $108.00 million. Eight percent interest on that amount is $8.64 million. Divide that by 90 days, and you get $96,000 per day. If the company reduces its cash gap by a single day, that $96,000 will flow directly to pretax profits.

For a real-life example, see the Dollar General case study, page 32.

SHRINKING THE CASH GAP

There are only three ways a company can reduce its cash gap:

Stretch out payment terms on purchases for inventory. In most industries, payment terms are largely determined by tradition (see "Different Gaps for Different Industries" at right). In the garment industry terms characteristically exceed 40 days, but in food processing they tend to be closer to 15 days. There may be some flexibility, but not a huge amount.

Shorten the collection period. The faster a company can collect for products, the smaller its cash gap will be. A company such as WalMart collects cash from customers when they walk out of the store, so Wal-Mart has no wait--zero days--to collect cash from sales. Similarly, Amazon.com takes a credit card payment before it ships a customer's purchases.

The nature of a business also affects timing of collections (at right). Unlike Wal-Mart and Amazon.com, other industries have inherently longer collection periods. Steel fabricators typically take 45 days. Some health care providers can have 60 to 90 days in receivables, thanks to slow-paying HMOs that actively manage their cash gaps by delaying payments.

Consider the Concrete Specialty Chemicals Co. (see exhibit 2, page 28)--based on a real company--which requires customers to pay cash for their chemicals up front, then orders the products shipped directly from the manufacturer to Concrete Specialty's customers. The distributor keeps no inventory, so inventory turnover is not relevant. The manufacturer gives 30-day terms, so Concrete Specialty has its customers' cash in hand for 30 days before it pays its supplier. The company always has cash on hand to pay its supplier because it receives cash even before it places an order. Concrete Specialty Chemicals has a negative cash gap--of minus 30 days.

Amazon.com also has a negative cash gap. At the end of 1998, Amazon.com reported zero receivables; 23 days worth of inventory; and 87 days in payables. This works out to an amazing negative cash gap--64 days. At that time, and with an average cost of sales of $1.3 million per day, the giant of Net retailers had managed to raise $83 million of interest-free capital from its customers earning it much admiration from investors.

Increase inventory turnover. The faster a company moves inventory, the less cash it needs. Managers readily understand how collection periods and payables periods affect the cash gap, but inventory turnover is another matter. It is hard for operating people to get an intuitive grasp of how their actions affect cash.

The cash gap graphic makes it much easier for them to understand. Remember exhibit 1, page 28? Part B shows what happens when High Tech Widget reduces its inventory to one-sixth its former level but nothing else changes. A reduction in inventory shortens the time that goods stay in process or storage awaiting sale, so the bar representing inventory days shrinks drastically, from 60 days to 10 days. As the inventory bar shortens, it pulls the bar representing receivables with it, reducing the cash gap by exactly the amount the inventory bar shrinks--50 days.

The cash gap drops to only 40 days even if management does nothing to change the collection or payables periods. The entire reduction stems from better inventory control. This inventory reduction leads directly to a drop in annual interest cost of $4.8 million (50 days X $96,000 per day). Shrinking the cash gap is good for the bottom line.

Inventory turnover also depends in part on the type of business (see case study, page 32). Dollar General has 101 days of inventory on hand compared to Concrete Specialty, a distributor, which has no inventory at all. Although inventory turns may not be influenced easily by financial managers, operating people can and will do this if they understand why they should. Nissan Motor Manufacturing Corp. USA reportedly keeps only two days of inventory at its Smyrna, Tennessee, plant. The company transfers title for all vehicles to its marketing arm as soon as it finishes production, so it carries no finished-goods inventory.

PREDICTING FUTURE CASH FLOW

The operating people who can improve inventory turnover are more conspicuously accountable for growing the top line. So far, we have looked at the cash gap at a fixed point in time. However, the cash gap also can warn a growing company about potential cash flow problems. Accordingly, both financial and operating managers should pay attention to the cash gap while they are growing the company, or the sales growth won't help the bottom line.

If both the cash gap and sales are growing, a company rapidly reaches a point at which cash outflow exceeds inflow--a situation that can quickly lead to bankruptcy. Even if the cash gap remains the same but sales grow, a company can run into problems. Exhibit 3, at right, shows what happens to the cumulative cash flow for a company such as High Tech Widget (60-day cash gap, 40% gross margin), at various sales growth rates.

[Exhibit 3 ILLUSTRATION OMITTED]

At a 10% sales growth rate (3A), cumulative cash inflows increase. Financial managers should use cumulative cash flow rather than the monthly net to minimize noisy short-term cash flow fluctuations.

Stepping up to a 15% sales growth rate (3B) and a 20% growth rate (3C), the cumulative cash flow remains positive. However, at faster growth rates, for instance 25% (3D), the cumulative cash flows become negative--cash outflows outpace cash inflows. The changeover point in this case is 21.1%. In cash terms, the company has "fallen off the edge"--any sales growth in excess of that inflection point drains cash out of the company. The faster the growth, the faster the company bleeds to death.

BLEEDING CASH TO GROW

Once a company has "fallen off the edge," additional sales growth will not improve its cash position. Exhibit 4, above, illustrates this.

[EXHIBIT 4 ILLUSTRATION OMITTED]

At a 30-day cash gap (4A) the cash inflow curve rises above the cash outflow curve; at a 60-day cash gap (4B), they are adjacent; and at 90 days (4C) the cash outflow line crosses above the cash inflow line. At 120 days (4D) the shortfall is even greater. As the cash gap grows, the inflow curve keeps getting flatter until the cash inflows are much less than the outflows.

When a company falls into this position, it must either reduce the cash gap, increase its margins or slow down the rate of sales growth until the cash flows come back into balance. Accordingly, a growing company cannot afford to neglect its cash gap.

Of course, the real world is more complex than this. Many companies grow in spurts. At some, the inventories rise and fall because of seasonal or weather-related factors. Or the cost of goods sold may be unpredictable because of commodity price swings. With many continually fluctuating variables, the cash consequences can be a lot more difficult to predict. It takes a pretty sophisticated computer model to reflect all that movement in so many variables. Nonetheless, the principle remains the same: An actively managed cash gap is essential to profitable growth.

[EXHIBIT 2 ILLUSTRATION OMITTED]

RELATED ARTICLE: Different Gaps for Different Industries

What cash gap is desirable? Generally, the shorter the cash gap the better, although how low varies wiith context. Some businesses-for instance, Amazon.com--actually have negative cash gaps. Grocery stores, filling stati6ns and hotels have very small cash gaps. Seasonal businesses such as farm machinery and snow removal equipment, and fashion-related businesses such as women's dress manufacturing, have the biggest cash gaps. In most cases, the cash gap for a service business--which has no inventory--is equivalent to its wait for receivables.

CASH GAPS BY INDUSTRY (in 1998)

Number of days in:      Receivables   + Inventory

Manufacturing

Bread and bakery            27            19
Meat packing                18            18
Bottled soft drinks         28            25
Cold roiled steel           44            26
Commercial printing/        53            21
Lithography
Paperboard containers       40            33
Women's dresses             55            37
Fertilizers                 42            54
Fabricated pipe             45            51
Farm machinery              58            76
Household audio             55            89
Electronic computers        73            91
Fabric mills                47            76

Wholesale

Office supplies             40            28
Auto                        17            63
Toys, hobby goods           49           118

Retail

Gasoline stations            6            10
Grocery stores               2            17
Drugstores                  30            60
Autos--new and used          5            64
Family clothing              6           107
Shoes                        2           159

Number of days in:      Receivables

Service Industries

Motels and hotels            8
Auto leasing                11
Cable and pay
television                  23
Airlines                    32
Equipment rental            35
Railroads                   47
Telephone companies         49
Accounting firms            79

Number of days in:      - Payables    = Cash Gap

Manufacturing

Bread and bakery            29            17
Meat packing                11            25
Bottled soft drinks         24            29
Cold roiled steel           35            35
Commercial printing/        30            43
Lithography
Paperboard containers       27            46
Women's dresses             38            54
Fertilizers                 37            59
Fabricated pipe             30            65
Farm machinery              37            97
Household audio             40           105
Electronic computers        45           119
Fabric mills                23           100

Wholesale

Office supplies             31            37
Auto                        10            70
Toys, hobby goods           35           131

Retail

Gasoline stations           13             2
Grocery stores              10             8
Drugstores                  35            54
Autos--new and used          2            67
Family clothing             39            75
Shoes                       54           107

Number of days in:                    = Cash Gap

Service Industries

Motels and hotels                          8
Auto leasing                              11
Cable and pay
television                                23
Airlines                                  32
Equipment rental                          35
Railroads                                 47
Telephone companies                       49
Accounting firms                          79

Source: Derived from information reported by Robert Morris Associates, Philadelphia. www.rmahq.org.

RELATED ARTICLE: CASE STUDY: Dollar General: A $400,O00-a-Day Cash Gap

Consider the case of Dollar General, a retail chain. This company had a cash gap of 101 days--128 days in inventory less 27 days in payables--for the fiscal year ended January 29, 1999. With annual sales of $3.2 billion, it generated average daffy sales of $8.8 million. Since cost of sales was 71.8%, it had to finance $6,318,000 for each day of its cash gap. If the company borrowed money at 7%, it paid $442,288 in interest for each day in its cash gap. Shaving just one day off the cash gap would add more than $400,000 to Dollar General's annual pretax profits.

GERMAIN BOER, CPA, is a professor of management at the Owen School at Vanderbilt University in Nashville, Tennessee. His e-mail address is [e-mail].3