How Much Cash Reserve is Enough?

How Much Cash Reserve is Enough?

”Cash is King” is the mantra of many small business owners. It is true that cash is the fuel that makes a business run. It is needed to pay salaries, fund marketing programs, acquire and retain new customers, invest in equipment and facilities, pay rent, supplies and the many day-to-day activities of a small business. But how much is enough? When does is make sense for the small business owner to share the wealth with key employees or take a distribution from the business? This blog will give some insights into figuring out how much cash to have in reserve.

Most financial experts recommend three to six months of operating expenses, but using this for every business in every situation is misleading. Regulating cash flow isn’t just about quantity. It’s about having enough cash at the right times. Having enough cash in Week Four doesn’t help when you don’t have enough cash to cover payroll in Week Three. Consider the following three key areas to help determine how much cash you need.

1. How Much Cash Have You Been Using?
Run monthly cash flow report from your accounting software. This report will provide an historical and seasonal perspective. Note the cash received from sales and the cash spent. Most cash flow reports will show you your net income for the given period and adjust the numbers based on how much cash you received from customers and how much cash you spent on operations; in essence removing Accounts Receivable and Accounts Payable from the equation. The net of these two is often referred to as the “net burn rate.”
Your “gross burn rate” only takes cash expenditures into account and is the more conservative analysis, since it does not assume any sales are made. Historical spending patterns are a good starting point in considering future spending plans.

2. How Much Cash Do You Plan to Use?
Look at the monthly cash flow projection covering the next 12 to 15 months. You should be able to find this information in your monthly budget, or if don’t have a budget, from a financial forecast created for this purpose. As you did with actual cash expenditures in the preceding paragraph look at the sales (cash in) and expenditures (cash out) separately.
Be conservative in your forecast as actual results often differ from what’s stated in your business plan. And keep in mind that expenses are usually more predictable than revenue because many are relatively fixed, such as payroll and rent.
For a small business, the past is not necessarily the best predictor of future needs. You need to consider the stage of your business in your forecasts.

3. What Is the Stage of Your Business?
Are you in start-up, first year of operation, maintaining an ongoing business that stays fairly consistent each month and year, or do you have plans to grow or make large purchases. Each of these will impact the cash forecast discussed above. While an established business may have good benchmarks, a start-up has few benchmarks and the most uncertainty, and thus should be more conservative when setting cash flow needs.
In growing businesses, accounts receivables, and maybe inventory, expand to support the increased sales. But it is often overlooked that you need cash to fuel this growth—you must spend money to generate the sale before the customer remits cash.

How Long It Will Take to Get More Cash?

Now you know your cash needs for the next 12-15 months. The next consideration is how long it will take to get more cash if and when it is needed. If you’re funding the business from your own resources, the time is short. Getting the needed funds likely means writing a check from a bank account or selling a security from an investment account—you might only need three to five days for the cash to be available to use.
However, if you need a bank loan to get cash, it might take two months or longer—one month to find a bank willing to make the loan and one or more months to do the paperwork. This option assumes you have a business plan in almost-ready condition and have maintained good relations with your bank if you have an established business or on your personal account if you’re in start-up mode.

Raising funds from angel investors extends the time considerably. If you go this route, count on six to nine months to prepare the business plan/investor pitch, make presentations to several angel groups to find one that is interested and a good fit, and wait while the angel group conducts its due diligence.

Once you know how much cash you’ve been using, how much you plan to use, and how long it will take to get it, you can determine how much cash you need to keep in the business. For example, if you plan to use a bank loan to fund your cash needs and you plan to spend $50,000 a month then you should probably keep a minimum of $100,000 in your bank account—if you have certain sales revenue occurring in these two months you can reduce the needed cash in the bank by a like amount. However, if you plan on using angel funding then you might want to have $300,000 in your bank account.
Before approaching a bank or angel group, consider some other funding sources

Are There Other Cash Sources?

There are many other sources of cash. For purchases, ask the vendor for credit terms or a longer period in which to pay. For sales, ask customers to pay you in shorter timeframe and offer a discount as an incentive to pay earlier. Other cash sources include increasing your credit card balances, taking out a home equity loan, borrowing from family and friends, tapping into savings and retirement accounts, leasing rather and purchasing equipment—the list goes on. It’s also good practice to have a bank line of credit as a safety net—one that can be dipped into when needed.

When Is the Best Time to Seek More Cash?

A common axiom is that the best time to obtain funds is when you don’t need them. Sounds counterintuitive, but during these times you aren’t desperate to take the only offer made. You have time to shop for the best source, with the best terms, and you can negotiate from a position of strength.

Too Much or Too Little Cash

There are many lists of common reasons for business failures. The two items frequently near the top are undercapitalization (not enough cash) and overcapitalization (too much cash). The first reason is pretty easy to understand. But companies can also get into trouble when they have too much cash, as they often undertake projects, hire staff, buy equipment, move to larger offices, and other such expensive actions, which incur ongoing implications like fixed costs.

Often these decisions are not made with the same planning rigor when cash was tighter. If your company is fortunate to have “excess” cash beyond the forecasted needs, then make a distribution to the owners or a bonus to your employees rather than make a decision that may have far-reaching effects.