October 31

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How much cash should a company keep?

I’m so fortunate that I don’t necessarily have to draw money out of my company to get by. I do from time to time any to cover some larger expenses, but mostly the money stays in the business. So much so that I now for two years in a row have used up almost all money in the company, and I nearly bankrupted the whole thing.

I have, of course, build up assets in the company, as I’m building a couple of websites with the goal of selling them. I’ve also spent money on completely useless SEO-tools and online courses just to play around with and have fun. It was fun, but it hasn’t earned me any money.

So as we transitioning from being “just” a founder to a CEO-type role we have to be more strategic about how much cash a company should keep.

In this article, you will learn…

We need liquid cash to make things happen in our business and pay unforeseen expenses.

Cash comes in handy for business valuation. If you are planning to sell your business or even if you are planning to raise finances the amount of cash that your business has will have a bearing on the entire decision-making process

Cash on hand will help you to tide over bad business cycles, or act fast if an opportunity presents itself.

We don’t want to keep too much cash as it will decline in value and doesn’t “work” for the growth of our company.

Keeping 3-6 months worth of recurring expenses as cash usually a good level for most businesses.

 

Whether we run a business, there is no denying the fact that cash is one of the most important components. As far as business is concerned it is one of the most convenient and popular forms of liquid currencies or current assets as we understand it in accounting terms. It is quite obvious that cash works like fuel for your business and therefore we must know how to manage it efficiently to run the business successfully.

However, at the same time, we must avoid a situation where we end up stocking too much cash in our company vaults. This will be considered as idle money and will not work for the productive purposes of the company.

Hence there is a need to find an answer to the question of how much cash should a company keep. It is not easy to find answers for the same and that is what my efforts will be over the next few lines – both for you and for my own company.

It will be useful for those of you who are running a business successfully and would like to take it to the next level. It also could come in very handy for new business entrepreneurs who would like to have a fix on this question before they start their business.

 

What is cash on hand?

This is a term that we often come across when we look at the accounting statements of companies. Cash In Hand means the total amount of cash that the company has. It also could include other current assets like cash in the bank and other assets that could easily be converted into cash. Cash in hand includes cash that is kept in change stores, cash registers, business checking accounts, business savings accounts, investments that can be converted into cash over the next 90 days, or in a lesser period.

Therefore, cash on hand will not include properties, factories, vehicles, cash that is lying invested in stock, long-term investments, investment in bullion, commodities, and other such things.

 

Why should a business keep adequate cash on hand?

There are obviously a number of advantages to keeping adequate cash in hand as far as your business is concerned. You need cash to keep paying the daily expenses and bills that keep accumulating regularly. You also need cash to meet the financial obligations and commitments that you have towards your vendors, customers, employees, and other stakeholders.

It comes in handy for business valuation. If you are planning to sell your business or even if you are planning to raise finances from various sources, the amount of cash that your business has will have a bearing on the entire decision-making process. It also will be helpful in estimating taxes and also for other such purposes.

Having adequate cash on hand will help you to tide over bad business cycles and it will act as a buffer during good times, so you can act quickly if a business opportunity presents itself. It also will be extremely useful if you are planning to expand your business or launch a new business in your endeavor to diversify your sources of income.

When sales are low and when cash-flow becomes weak, having adequate cash reserves will be extremely useful and will help your business to stay afloat till such time sales and revenues pick up. You will be able to manage your future expenditure better and in case of some unforeseen happening or natural disaster, cash in hand could be the savior till such time things return to normal.

 

Is it good for a company to have a lot of cash on hand?

The answer to whether it’s good for a company to have a lot of cash on hand is somewhat a Goldilocks-situation. Having cash equal to 3 to 6 months of the business operating expenses is the generally accepted norm. In the event of a downturn or something going wrong, you’ll have enough time to make adjustments. On the other hand, this is not an amount of cash with too big of an opportunity cost that causes your business to operate inefficiently. In my example, my monthly expenses are about 1,800 $, so I would need to stock between 5,400 $ and 10,800 $

As an example, Mike Michalowicz points out in his fabulous book Profit First, that 3-6 month of recurring expenses is needed as a buffer for your business.

This will of course mean that you know what opportunity cost is, and what your business monthly operating expenses are. More on that later.

As Investopedia points out there are two ways to look at the question: “(A lot of cash on hand) shows that cash is accumulating so quickly that management doesn’t have time to figure out how to make use of it. (…) Cash could be there because management has run out of investment opportunities or is too short-sighted and doesn’t know what to do with the money

While it is a fact that having adequate cash in hand, is a healthy way to run a business, many firms make the mistake of sitting on huge amounts of cash. This could be counterproductive and may create problems. Investors may not look at this favorably. They may ask the question as to why the excess cash lying in various forms is not being used for expanding the business, adding new products, or even diversifying to some other activity so that the risks of the business are evened out.

On the flip side, if the balance sheet shows healthy cash on hand position, it will mean that the company is able to generate strong revenues. Companies that are just capital-intensive may often find it difficult to raise cash because they need to replenish equipment and this cannot be done overnight and it will take some time. This could impede their current operations and may result in a dip in revenues. Investors will be able to make a better assessment of the company’s cash needs by having a look at important things like business cycles, future cash flows, capital expenditure plans, and also various upcoming liability payments.

One of the best and most direct explanations I’ve found on this topic is in this article on capitalwithstrategy.com

 

Some bad reasons for sitting on extra cash

There is no doubt that sitting on huge chunks of hard cash could be an expensive luxury for any company. Holding on to excess cash comes with an opportunity cost attached to it. Opportunity cost is measured by finding out the difference between interest earned on cash holding and the price paid for having that much cash in your company vaults and other such places. This is also measured against the cost of capital and quite often it is true that the cost of capital of the company may have come down quite significantly.

Let me try and clarify this with an example.

The company may perhaps be in a position to get an annualized return of 20% on equity by investing in a viable project. It may also be in a position to get perhaps the same amount of return by expanding the business. In such situations, earning peanuts from the excess cash lying in the company is a costly mistake.

In case the return on new projects or expansion of projects is not equal to the cost of capital of the company, the best option would be to return the cash to the shareholders rather than allowing it to remain idle.

 

What are the disadvantages of cash?

If a company has excess cash, it often invests in short term instruments and bonds. These investments are highly liquid in nature and therefore can be converted back into cash almost immediately. Yes, this is about playing it safe. But we also need to bear in mind that these short instruments have very low yields and therefore as a company, you may not be able to make a big earning out of these investments.

 

1. Inflation devalues your cash

Businesses are all about being able to take some amount of risk. Unless you are able to do this as an entrepreneur, you will not have everything going your way. This approach depends on low-yielding bonds will not be able to cover inflation and you may find that the interest earned will be lower than the rate of inflation.

 

2. You get prone to careless problem-solving

Excess cash can also put you in a position to make careless mistakes. This is a general principle – Murphy’s Law I believe. Time and money will expand or contract to the need. So If you have a short time to finish something, you will do it faster. If you have enough money you will spend them in full and not be as careful.

Rather than being diligent and seeking out new opportunities, you might be trying to just pay your way to the solutions. Just throwing money at problems might not solve them in a sustainable way.

 

3. You will see limited growth

One of the biggest disadvantages of having a large cash balance is that it may put a brake on the ability of the company to grow.

As mentioned above, it is critical that the business does maintain some liquid cash assets. There are some proven ratios that could be followed. Anything excess should go in for business expansion or getting into new activities or diversifying the existing business and increasing the revenue-generating streams.

Excess cash can also be used to improve the quality of human resources by hiring efficient and more capable staff. It could also be used to motivate performing and committed staff. If the company has any long-term or short-term debt, a part of the excess cash could be used to retire those debts so that the debt to capital ratio becomes even stronger.

It is a decision that the entrepreneurs, or the people who are at the helm, should take.

 

How do you know if a company has enough cash?

As a company owner, if you wish to know if it has enough cash then there are a few things that must be assessed. The amount of cash in hand, the uncertainty of cash flow, the timing of the cash flows are some of the most common things that are taken into account while reporting cash flow statements. In other words, when experts look at the cash flow position of the company, they take into account the above three factors.

There are some proven, time-tested and reliable ratios that are used to find out the strength or otherwise of cash flow situations of a company. I have listed down a few of them for you here.

 

Debt-service coverage ratio

Companies that are extremely profitable may fail over a period of time if their regular operations are not able to generate the required cash that helps them to stay healthy and liquid. Profits could be tied up in some outstanding receivable accounts or overstocked inventory. It could also happen if the company ends up spending heavily on various types of capital expenditures.

Creditors and investors, therefore, make use of the debt-service coverage ratio to find out if a company has enough cash or equivalents of cash so that it does not struggle in settling short-term liabilities.

The debt service ratio is quite simple and is obtained by dividing short term debt by net operating income that the company has. However, this figure may not tell the entire story. The company may have camouflaged the future growth prospects so that the debt-service coverage ratio looks rosy.

 

Free cash flow

Free cash flow may be a good way for companies to know more about the profitability of the business. It measures the financial performance and it often may be in a better position to throw more light than net income. This is because it clearly indicates the amount of money that is left with the company either for returning it to shareholders or for using it for expanding the company activities.

This ratio is arrived at after payment of dividends, paying off debts, and buying back stock. The formula for calculating free cash flow is dividing capital expenditures with operating cash flow.

 

How much cash flow is good?

What should be the answer to the question as to how much cash flow is good? The bigger the cash flow amount the better it is from a standard point of view. However, as a company owner, you must know what exactly is good. Good is subjective and it could have many meanings and connotations in different situations. It also varies from one investor to another. There are some companies that look for a minimum ROI or Return on Investment or their capital. On the other hand, there are some aggressive companies that look for a business result that, at the end of the day, is able to generate the required net cash flow. This, they believe, will go a long way in meeting the budgeted returns.

When we talk about ROI and try to draw some meaning out of it, we will be able to find out profitably or otherwise, your investments or capital is being used. This again can be derived through a simple formula that compares the net profit of your company to the overall cost of your investments and other expenses.

 

A few more important tips

Having a regular and closer look at the overall financial situation of your company is what any sensible business would do. There are various things he would like to know about his business and here are a few more things that could help you to find the right answer to the question as to how much cash should my company have.

  • How liquid are the other assets? While liquid cash and other equivalents are the best definition of cash in hand, you may also like to have cash in hand that could run into a few months. This becomes all the more true for niche industries that are invested heavily in different types of specialized machines.
  • You also would like to know if your overall wealth is appreciating or depreciating. If some key assets are appreciating, you can afford to have less cash in hand.
  • Spending situation. When reading through the balance sheet, it would be a good idea to find out how much of the spending is mandatory and how much is discretionary. If the weight of your discretionary expenditure is more, you may be in a position to hold less cash.

 

Conclusion

Getting the right fix as to how much cash should be held by a company is not easy. There are many factors that could determine it and therefore it may not be possible to have a straight-jacketed solution to it. However, there are some proven benchmarks and yardsticks, and ratios that could help companies in this endeavor.

 

Action steps

And now over to you! Are you ready to talk action, and do something good for your business?

  1. Calculate how much you need – Personally, I found by looking through a full year of bank statements and typing in Google Sheets, that I would need around 10-15,000 $ in cash reverses (It took me only an evening to do, and now I’ve secured my business financial future)
  2. Find a place to keep the cash. Set up a separate account – Like Mike Michalowicz points out in his book Profit First you will dive into your cash reserves as you dive into a cookie jar. You will it all up, and find a way to spend it. Therefore you need to make it more difficult getting to that money. For this reason, I’ve set up a new holdings account in another bank where it will take me two complete business days to get the money out.
  3. If you don’t have the cash set up and savings regime – I’ve sure didn’t have 6 months’ worth of operating expenses laying around. So I had to put a “savings plan” in place. In addition to my regular transfer for recurring expenses, I transferred an extra 5 % of my net income to my new account until I had a total of 15,000 $ saved up.

Easy as 1, 2, 3. Take the first step now.

 

Treasure your cash
Photo by Suzy Hazelwood from Pexels

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