In one of our training courses we demonstrate the concept of the financial gap but it’s sometimes difficult to get the head around it first time.
The gap arises because the business grows its revenue (or turnover) faster than its own internal sources of funding can support and the growth results in a need for additional external funding which will negatively affect the balance sheet structure.
The growth issue is one that many businesses struggle with because, after all, if they see an opportunity for growth, they’re going to take it – and then think about the financial effects later.
For those businesses that are working capital reliant, the growth in revenue must result in a bigger need for working capital so the asset side of the business grows as the revenue grows. If the management doesn’t change the way in which it collects accounts receivable (trade debtors) and turns its inventory (stock), the percentage increase in assets will be the same as the percentage increase in revenue.
It’s this increase in assets that has to be funded and which causes all the trouble. Some of the required funding can come from an increase in accounts payable (trade creditors) but the rest can only come from additional capital (being added through an injection of fresh funds or more retained income) or increased debt.
It’s when the gap is filled from debt that we’re concerned, of course. If we are the lenders, it makes sense to construct the projected balance sheet to find out just how much debt is going to be required in the coming year based on the revenue growth that the business is planning to generate.
We’ll take a closer look at how the financial gap is calculated in a Slideshare presentation that we’ll post on the site shortly.