A common question we see is: “How much cash should a business have on hand?”
JPMorgan Chase & Co found that the median small business kept only 27 days cash buffer in reserve and the U.S. Bank found that 82 percent of businesses fail because of poor management of cash.
WHY DO BUSINESSES NEED TO KEEP CASH ON HAND?
There are a few key reasons a business should keep cash on hand. Perhaps most importantly, it helps businesses cope with unexpected situations like inflation, a slowing economy, or a sudden emergency.
Even if your business is stable and in an industry with consistent cash flows -stuff – happens. Whether its an equipment failure, the entrance of a new competitor, new regulations, or a global pandemic, reserve funds help businesses pay rent, employees, suppliers, and bills during difficult times.
But it’s not all doom and gloom. Of course, just like how bad – stuff – can happen, so too can unexpected opportunities arise. Keeping cash on hand lets you take advantage of these potential short-term opportunities as they come up.
By keeping a cash reserve you’ll have immediate access to funds to invest, thus increasing your chances of success without losing the time needed to wait for financing.
WHAT IS A HEALTHY CASH POSITION FOR A SMALL BUSINESS?
As a general rule of thumb, the answer to: ‘How much cash should my business have on hand?’ is:
Businesses should aim to keep three to six months of average operating expenses in reserve.
This allows a business to maintain operations in the short-term even if there is an emergency, and gives the flexibility to take on new opportunities.
However, this number can vary significantly depending on factors like the industry and stage your business is in, other available financial resources, past expenditures and business goals.
The size of your desired cash reserves will change with:
• The stage your business is in (ex: startup, venture capital backed, growing, established)
• Your business goals (ex: expansion, investment)
• Your industry (Is it well established? Is there high pressure form competitors? Is cash flow seasonal?)
• The size of your business (single owner, small business, large organization)
• How quickly do you generate cash? (and how quickly do you spend it?)
• How easily you’re able to access short term funding (bank, line of credit, investors,)
HOW DO I DETERMINE MY CASH RESERVE NEEDS?
Of course the more volatile cash flow in your business or industry the more cash on hand you’d prefer. However, this needs to be balanced with the current usage of cash.
When setting the amount of cash the to be kept at the disposal of your organization, keep in mind it’s important that you have something that is comfortable, but also gives you flexibility.
CASH FLOW FORECASTING
A cash flow forecast is a great way to see the amount of cash you have, and will need. Cash flow forecasting allows you track the inflow and outflow of cash through your business, as well as predict, plan and test future scenarios to ensure you have enough cash to meet your goals.
Cash flow forecasting also gives you greater insight into your accounts receivable and payable helping to optimize things like bill payments and plan for the future
HOW DO YOU INCREASE YOUR CASH RESERVES?
1. UNDERSTAND YOU CURRENT SITUATION
If you don’t already have a solid understanding of you financial situation take a look at you financial statements. We also recommend creating and maintaining a cash flow forecast. Ask us how we can help.
You goal here is to understand where your business is at and going.
2. SET A GOAL
This may sound overly simplistic, but many small businesses simply don’t have a target cash reserve. An easy way to start is to plan to set aside a set amount every month. Mentally try to treat this goal like you would any other bill or cash outflow – you wouldn’t stop paying your rent or website bill.
3. WAYS TO IMPROVE YOUR CASH FLOW
At the end of the day it comes down to cash, but that doesn’t necessarily just mean: “sell more”. Of course we’d all like to, but that isn’t always realistic, and there are other methods we can use to improve our cash flow:
If you can’t increase sales an obvious second place to look is at reducing expenses. Perhaps, less intuitively are things like improving your collection time on receivables and optimizing your bill payment. For more check out our article on cash management here.
THE BOTTOM LINE
In general, businesses should aim for a cash buffer worth three to six months of their operating expenses. This helps them get through difficult short-term periods, cover emergencies, and quickly capitalize on opportunities.