So what is a cash gap analysis and what does it means in business valuation?
Well, cash gap analysis is the process by which the cash gap is evaluated: its size determined, its average length of time calculated, and its causes identified. More generally, cash gap analysis can help demonstrate how capital flows within the company. Its purpose is to raise awareness of the way capital flows so that plans can be developed to better manage the company’s cash flow.
A company turns its inventory six times per year, pays for its inventory in 50 days, collects its receivables in 60 days, and earns a 30% margin on its sales. That is, sales minus the cost of the inventory sold equals 30% of dollar sales. Average daily sales equal $15,000. The following graph visually depicts these relationships.
The company pays for its inventory 50 days after it arrives, keeps it another 10 days before selling it, and collects 60 days after that. Thus, the company must cover 60 days of sales by borrowing from the bank. This amounts to 60 x $15,000 x (1-.30), or $630,000.