How Much Cash Should Your Business Keep?

How do you know whether you have enough cash in your bank account? This is a common question in both business and personal finance. My guess is you're taking one of the following approaches:

• A random amount of money that "feels" right
• Don't think about it until you realize it's time to run payroll
• Stockpiling cash in your basic business account like a prepper
• You've actually sat down and calculated the proper amount of funding you need

Why should your cash balance matter to you?

1. Covering day-to-day ops — It should be obvious that we always want at least enough cash to keep our business running day-to-day (payroll, rent, utilities, credit cards, loan payments, etc.)
2. Working capital cushion — There's the wonderful (sarcasm) lag between spending and collecting cash called working capital. If your business has lots of A/R or inventory, then you'll want extra cash to stay afloat during those lags.
3. Growth capital — Most of us want to grow our business. Expansion costs can really add up (opening a new location, hiring more staff, new equipment, acquisitions) so you’ll need extra cash to make it happen.
4. Emergency reserves — In investing, downside protection is usually more important than upside. That rule is maybe more applicable in business. The number one rule is to stay in the game.

What about some strategies for determining cash reserves?

Here are 2 simple approaches to it:

1) Months' operating expenses

Simply take your annual (or projected) operating expenses and convert to a monthly figure (i.e. divided by 12), then multiply by 2 and that's your minimum cash on hand.

Minimum Cash on Hand = Monthly Operating Expenses x 2

For example, a business with $600,000 in annual operating expenses should keep a $100,000 cash reserve on hand. [$600,000 / 12 months x 2 = $100,000]

Drawbacks for this approach -- It doesn't incorporate: 1) your current level of profitability; 2) your working capital; 3) the relative size of operating expenses to revenue. So consider this approach a very loose framework to get you in the ballpark of an appropriate cash level.

2) Working capital approach

This is my preferred approach... we really want to look at the financial stats of our entire business. That means we include profitability (or expected profitability), operating expenses, and cost of goods sold.

Here's the formula:

Cash on Hand = (Daily Expenses x CCC in days) + Safety Buffer

Let's walk through an example...

• Daily Expenses — Say my business does $1m in annual sales at a 5% profit margin ($50k per year). That means my total expenses (both operating expenses and cost of goods sold) must be $950k per year ($1m minus $50k profit). That works out to $2,600 per day ($965k divided by 365 days in a year).
• Cash Conversion Cycle (CCC) — Remember, this is how long money is tied up in your business before you convert it to cash (and thus earn your profit). The number expressed here is in days.
• Safety Buffer — Adding a buffer to your cash on hand is partly dependent on your risk tolerance and partly dependent on your business.

Back to the example... If my CCC were:

• 50 days, then I should keep $130,000 cash on hand ($2,600 x 50).
• 25 days would be equate to $65,000
• 100 days would be $260,000

We can see the longer cash is tied up in our operating cycle, the more cash we'll need to cover the gap!

Let's say the breakdown of my $950k annual expenses are $500k COGS and $450k operating expenses... using 2 months of opex ($450k / 12 x 2) = $75k minimum cash which is higher than the 25 day CCC example. Maybe in that instance I'd want to add a safety buffer to allow for larger potential cash drawdowns throughout the year.

Some additional considerations:

• If you have steady or highly predictable revenue streams (subscriptions, retainers, etc.), then you probably need less on hand at any given time
• If your business is highly seasonal, then you should factor in a larger safety buffer

Key Takeaway — You don't need to sit down and crunch numbers every week to know how a minimum cash level you should aim for. But you should run the math a few times a year. Adequate cash reserves are important for the reasons above (run day-to-day ops, working capital, growth capital, downside protection).

Send a reply if you need help working through this in your business. We're here to help.