tim-sernettWritten by Tim Sernett, Small Business Accounting and Finance Advisor for Entrepreneurs

As business owners we all understand the importance of cash flow and having enough cash on hand to cover our obligations to our team, to our vendor partners, and to our customers.

We all see a lot of chatter about cash flow in business blogs, books and publications. Most are focused on managing cash flow and/or improving cash flow, which of course are extremely important to the survival of your business and require a level of business financial literacy to pull off. However, in those publications, rarely is the following simple question answered:

How much cash should my business have on hand?

What’s the end objective to cash flow management and cash flow improvement? Obviously, a big part of any small business is for the owners to put more cash in their pockets. But if the owners are always depleting the bank accounts, even as cash flow hopefully improves, have we eliminated any of the stress and pressure of cash flow short falls? So just how much cash should be left in the business?

One of the simple end-goals (and there are many) of improving cash flow and implementing sound cash flow management is to have enough cash reserves on hand to comfortably sustain the business.

Unfortunately there is no hard and fast standard amount or a set ratio, and it’s mostly opinion and your comfort level as a business owner. The standard “rule of thumb” is that most businesses will operate smoothly with enough cash reserves on hand to cover three to six months of average operating cash outflows. But you need to decide for yourself what your comfort level is, and several factors need to be considered.

cashonhandIs your business seasonal or are expense levels consistent throughout the year?

Seasonal businesses will have to adjust the amount of cash on hand to sustain them depending on the time of year.

Are you expecting a rapid growth period on the near future?

Contrary to popular belief, growth actually puts a lot of stress on cash flow and increases cash needs.

Do you have immediate equipment or space upgrade needs?

If so, be sure to have a good understanding of the impact of those purchases on your cash flow.

To further define your comfort level, ask yourself some “what-if” scenarios – What if we lost our two or three best customers in the same month? What if 2008 and 2009 happened again and sales dropped 30% or more, how quickly could we adjust and how much cash would we need?

Now let’s quickly define what it is you want to cover for three to six months.

First calculate your average monthly “cash” overhead costs, such as rent, utilities, insurance, administrative staff, leases, debt service requirements, etc. Next calculate your average monthly production costs based on average monthly sales – if sales dropped drastically you’ll most likely want to continue to maintain minimal inventory levels or manufacturing output for a short time, and if you’re a service provider you’ll want to continue to fund salaries and benefits for key personnel – yes, that includes you, the owner. Combine your overhead and production costs to come up with your three to six months figures.

Now that you’ve done that, which is it, three or six months average operating expenses?

Hard to say, and like I said some of it depends on your comfort level. It should also be guided by your strategic business plans for the next 12 to 24 months. Those strategic business plans should include some full financial statement projections that are reviewed at least quarterly. Full financial projections are the only way I know of to truly answer the question of how much cash your business will need, when your business will need it, and where it’s going to come from.

With full financial projections you can see how the cash reserves in your business will react to different scenarios and adjust accordingly. Short of that, at least you can use the above to establish the rule of thumb for your business.

Have questions or want to learn more? Email or call me at tim@thevirtualbeancounters.com or 913.649.1040.