Does your business frequently struggle with cash shortfalls? When owners and managers want to drum up additional cash, they often focus on building revenue or cutting expenses. Similar to crash dieting without exercise, however, such strategies ignore the link between efficient working capital management and a healthy bottom line. By optimizing the cash gap, your business can improve profits, strengthen its balance sheet and improve liquidity.
Why the cash gap matters
The “cash gap” is a simple concept that may appeal to owners and managers who work in the trenches. Also known as the cash conversion cycle, this metric represents the number of days a company must finance its operations before collecting cash from customers. It’s especially relevant for companies with tight margins, seasonal sales fluctuations or long production cycles. Businesses that fail to manage their cash gap effectively may have trouble making payroll, paying vendors and meeting other short-term obligations — even if they appear profitable on paper.
The cash gap is usually funded by the owner personally or with the company’s line of credit, which incurs interest. A shorter cash gap means a business cycles cash through operations more efficiently, reducing the need for external financing or excess working capital reserves.
How to measure the cash gap
Calculating the cash gap starts with three metrics:
- Days inventory outstanding (DIO), the average number of days inventory is held before being sold,
- Days sales outstanding (DSO), the average number of days it takes to collect payment from customers, and
- Days payables outstanding (DPO), the average number of days a business takes to pay its suppliers.
The cash gap equals the DIO plus the DSO minus the DPO. For example, suppose ABC Co. carries about 60 days’ inventory in its warehouse, collects its receivables in about 50 days and pays off its suppliers within 20 days. ABC’s cash gap would be 90 days (60 DIO plus 50 DSO in receivables minus 20 DPO).
How to shrink the cash gap
Companies have three options if they want to streamline working capital management, each directed at one of the variables that make up the cash gap:
Reduce inventory. Businesses sometimes stock extra inventory to ease anxiety about price increases or supply shortages. However, excessive inventory causes companies to incur unnecessary carrying costs, which erodes profits. These costs may include extra warehouse rent, insurance, interest expense, pilferage and obsolescence.
There are numerous ways to minimize a company’s investment in inventory. For instance, the business should periodically search its warehouse for slow-moving items and then return stale items for credit, trade them with another supplier or competitor, or sell them for scrap. Companies can also revise their purchasing policies. For example, some suppliers may agree to discounted bill-and-ship or consignment arrangements in exchange for exclusive or long-term contracts. Conversely, larger businesses with more complex inventory may benefit from materials requirements planning systems that minimize inventory by sharing customer data with suppliers.
Speed up collections. The faster a company can get money in the door, the lower its cash gap. Effective ways to encourage faster payments include:
- Performing credit checks on prospective customers,
- Flagging new customers to ensure initial invoices are paid on time,
- Sending out past-due reminder letters with follow-up phone calls,
- Hiring dedicated collections personnel,
- Offering “early-bird” discounts to customers that pay within 10 or 20 days, and
- Tying sales commissions to collections as opposed to gross revenues.
Evaluate invoicing procedures and consider automating, where appropriate, to minimize the days in receivables. Poor communication among billing, sales and production staff can also cause delays.
Extend payment terms. When your business holds off paying its suppliers, those vendors wind up providing a form of interest-free financing. There are limits to how far a company can stretch its payables, however. Slow-paying businesses may forgo early-bird discounts or receive less favorable treatment from suppliers, such as slower delivery, higher rates or cash-on-delivery terms. In addition, delayed payments can harm a company’s credit rating and reputation among its pool of eligible suppliers.
Be Proactive, Not Reactive
In today’s uncertain markets, managing the cash gap is critical to an effective financial strategy. By proactively implementing best practices and leveraging technology, your business can optimize its cash cycle, maintain healthy liquidity, preserve profits and sustain growth. Contact your accountant for help evaluating your cash gap and implementing additional working capital management strategies.
© 2025