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What Is Cash Trap
In business, a cash trap can have a few different meanings depending on the context in which you are using this phrase.
The most common meaning of cash trap is in accounting.
When companies spend more and absorb more money than they generate, they are known to be in a cash trap even though they may be able to show profits on paper.
For example, a rapidly growing company may experience significant growth in business operation costs leading it to produce more and sell more (technically being profitable) but cannot collect as rapidly causing it to rapidly drain its cash reserves.
If the cash reserves are drained and the company cannot access additional credit facilities, the company’s operations may end up with solvency issues and possibly go bankrupt.
Cash trap has other meanings in business as well.
Keep reading to find out.
But first, let’s look at the cash trap in accounting in more detail.
Cash Trap In Accounting
Business owners and companies understand how critical it is to properly manage their cash flows.
When you have positive cash flow, you have the ability to use that money to reinvest in your business and achieve further growth.
However, a negative cash flow can mean the opposite.
With a negative cash flow, your business can suffer as it may need to find alternative sources of capital to fund its operations, reinvest in the business, and fund its growth.
As they say, “cash is king”!
With that said, in accounting, a cash trap refers to the timing difference between when you pay your suppliers and when your customers pay you.
When you sell your goods and services, clients are required to pay you for their purchases.
In some cases, clients pay you upfront and in other cases you may grant your clients time to pay.
There are also some clients that are delinquent payers and, unfortunately, others where you’ll realize that you will need to reclassify the receivables as bad debt and eventually write it off.
Running a business means that you must pay for your business operations.
You have employees, rent, suppliers, expenses, and other costs to pay to properly manage your business.
Depending on the type of expenses that you have, your suppliers grant you some time to pay for their invoices.
In some cases, you’ll need to pay upfront, net 30, net 60, or longer.
Cash Inflow And Outflow
When you have less cash coming in from your sales and customers and have more cash going out to pay for your business operations and expenses, you are falling into a cash trap.
If on average, you collect your accounts receivables in 90 days and you are required to pay your suppliers within 30 days, you are effectively out of pocked 60 days where you are funding your business operations.
Companies that have access to a lot of capital may not be concerned about funding a 60-day cash trap.
However, new businesses and companies growing very fast that has a significant need for cash to fund their business operations are at risk of falling into a cash trap if they do not manage their cash flow effectively.
If your business operation costs are growing faster than your sales and you are collecting your accounts receivables at a slower rate than you are paying your accounts payable, you should immediately consider implementing measures to deal with the risks of falling into a cash trap.
Cash Trap In Contracts
In contracts, there are certain types of contracts where you are likely to see cash trap provisions.
Particularly, in real estate financing, loans, mortgages, or other types of debt agreements, lenders may include a cash trap trigger to protect themselves when certain covenants are not satisfied.
The way cash traps work in debt financing is that when the borrower fails to meet certain covenants, cash flow generated from the collateral asset will be paid into a separate account operated by a third party agent.
The cash flow is essentially “trapped” for the period of time the borrower is unable to meet certain contractual covenants.
If the covenants are met within a certain time period, the cash is released by the escrow agent.
However, if the covenants are not satisfied, the lender will impose a mandatory prepayment of the loan.
Cash Traps Takeaways
So there you have it folks!
What Does Cash Trap Mean
Cash trap is when a company is draining cash, working capital, retained earnings, and credit facility at a rate faster than it is collecting money from its customers.
If a company stays in a cash trap for too long, even though it may be generating a lot of sales, it can quickly become insolvent and potentially bankrupt.
In contracts, a cash trap provision is a contractual clause allowing a lender or contracting party to redirect cash flow from a collateral asset to a third party when the borrower fails to observe certain covenants.
A cash trap event can be contractually defined leading to the redirection of the cash flows to a third party protecting the lender until the borrower can cure the default.
If the default is cured, then the cash is released.
If the default is not cured, the lender may exercise different types of recourse as provided in the contract.
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