These businesses may struggle to pay their bills on time and will likely be in a state of negative cash flow despite being profitable.
Typically, the main causes of a cash gap are:
- Accounts receivable (sales invoices dragging out or terms are too long).
- Too much stock (e.g., you buy $20,000 but only invoice $10,000 this month, so you end up with $10,000 of excess stock you still need to pay for).
- Accounts payable (e.g., you are on seven-day net terms with your supplier but you’re invoicing your clients on 30 days EOM).
If you don’t fix a cash gap but continue to grow your business, the size of the gap, in dollar terms, will only get bigger.
The first instinct of most people is to try to increase sales revenue or income to fix a cash gap, but this will only fuel the fire. So, how can you fix a cash gap and keep building your business for success?
Try the following strategies before you continue with growth:
1. Reduce your inventory or speed up stock turn
You might like to use a simple rule of thumb or heuristic like: ‘If we can’t sell it this month, we don’t order it this month.’
The intention is to get your team to be aware of what they’re buying and the impact that has on cash flow. If you have vehicles on the road, consider a min/max inventory system – don’t drive around with stock you’ve paid for that you don’t need.
2. Rethink your Accounts Receivable terms
You might like to change your payment terms to keep the cash coming into your business more regularly. For instance, you might:
- Reduce your Accounts Receivable payment terms; if you are currently at 30 days EOM, make them 30, 14 or 7 days net.
- Apply payment-on-the-spot terms for do-and-charge or smaller fixed price work.
- Charge interest on overdue invoices, if appropriate.
- Automate and systemise your collection and reminder process.
- Incentivise early payments with small discounts. (Just be aware this will help your cash flow but reduce your gross margins.)
Remember, the payment terms you state on your invoice is your ideal scenario. I have rarely seen an invoice with 30 days EOM paid any earlier. If you don’t ask, you won’t get!
3. Extend terms with your Accounts Payable
This requires trust from your suppliers. Some will give it a go immediately, but others will need to see some history with you before they budge. I suggest looking for suppliers that have more favourable terms; with big suppliers, try to push your payment terms out to 30, 45 or 60 days EOM.
When it comes to your subcontractors, it’s helpful to think of them as wages that are recorded in COGS. Staying on good terms with them is critical, and you need to have the cash flow to be able to pay them on time.
Be realistic and understand the terms you have with your clients and how your cash flows. Then, make sure your terms with your subcontractors are manageable. You may need to have a mix of terms with subcontractors, e.g., some on 7, 14 and 30 days net.
4. Fund the gap with capital
To fund a cash gap with your business’ capital, you need complete visibility across all your business financials.
Typically, you have three options:
- Debt: You can borrow money… but be cautious. Any interest you pay on borrowed money can reduce your margins and profitability, and if any of your clients don’t pay you, you are still liable for the loan.
- Equity: You can raise capital through selling part of your business to investors or equity partners. This is harder to achieve and can be a difficult process.
- Retained earnings: You can build your own capital through profit. Often this is the only option available for small- to medium-sized businesses, however, it first requires a profitable business to begin with and can take time.
Finally, it’s imperative you have an excellent working relationship with your accountant. If your accountant is simply doing regular compliance work for you at the moment and offering nothing else, then it’s probably worth finding a firm that can provide real strategic solutions as you grow.