Funding Gap

The Funding Gap Per $1 Sales = $1 X (Receivable Days + Inventory Days - Payable Days)/365.

A business will have a widening funding gap when their receivables and inventory balances increase at a faster rate than the rate of retention of free cash flow.

This most frequently occurs when the company is experiencing rapid growth of sales.

Free cash flow = Operating income - Fixed capital expenses - Debt repayments - Debt service payments - Taxes.

Inventory days = (Inventory/Cost of goods sold)*365.

Receivable days = (Receivables/Sales)*365

Payable days = (Payables/Cost of Goods sold)*365

Calculation example:

Our demo company has the following sales and balances at the year end:

Sales = 16,567,000
Inventory = 2,000,000
Cost of goods sold = 14,987,000

Then:
Inventory turnover = 14,987,000/2,000,000 = 7.493
Inventory days = 365/7.493 = 48.7 days.

Receivables = 1,756,000
Then:
Receivable turnover = 16,567,000/1,756,000 = 9.435
Receivable days = 365/9.435 = 38.7 days.

Payables = 1,238,000
Then:
Payables turnover = 14,987,000/1,238,000 = 12.106
Payable days = 365/12.106 = 30.1

Funding Gap = 48.7 + 38.7 - 30.1 = 57.3 days

The funding gap represents the number of days between the time money is paid out to suppliers until it is received back from customers.

In our example, counting when goods/materials are received from suppliers as day 0, the average inventory holding period (until products are sold) is 48.7 days. The average time to pay for goods/materials is 30.1 days, and the average time to receive payments from customers from the date shipped is 38.7 days. 48.7 - 30.1 + 38.7 = 57.3 days delay from when goods/materials arrive in stock.

This is the time gap that the need for working capital arises. The actual amount is easily calculated from this next equation:

Working capital per $1 of sales revenue = ($1 x funding gap days)/365.

In our example:
The company has annual sales = 16,567,000.

So its working capital needs (funding gap) = 16,567,000 x 57.3/365 = 2,600,792.

Note that the extra amount of working capital required if the company forecasts a 10% increase in sales next year is easily calculated:

16,567,000 x 10% x 57.3/365 = 261,441.

Reference Pages

Working Capital Sums

Good Performance Model