As any business owner will testify – running out of cash is the death blow to the existence of any business.
Definitely not good.
It’s a big stress, especially not having the liquid funds necessary to meet important demands such as payroll. At the same time having cash sit idle wastes the chance for investment, allowing the business to miss taking advantage of growth opportunities.
So, the question arises: What is the right amount of cash a small business needs on hand to be able to meet the cash demands of their business while also supporting opportunities for investment and growth?
Conventional wisdom states that all businesses need between 3 to 6 months of operating expenses saved in cash or highly liquid investments.While this wisdom is sound, a more prudent method would be to separate cash into both a monthly operating account and a contingency account.
Let’s take a look at how this method of cash flow management can be implemented in your business.
The Operating Account would maintain a sufficient cash balance to cover the lowest cash flow month or period of the year for the business. For example, a seasonal business carries enough cash to last through both the busy and slow seasons during the year.
A Contingency Fund would maintain a cash balance equal to 3 to 6 months of operating cash based on potential worst case scenarios or growth objectives.
Now let’s cover specifics below. The following three steps can be used to determine how much the business should allocate for each of these accounts.
Step 1 Calculating your actual costs
Begin by analyzing the last 12 months of costs. Break this down into production costs minus the costs of goods sold in your manufacturing or distribution business. If you have a service business, calculate the cost of sales and all the overhead costs spent every month without regard to the sales volume.
Step 2
Take your current bank balance, outstanding account receivables, inventory value (an estimate will work) and subtract your annual liabilities such as taxes due, accounts payable, and loans payable.
Then divide by 365 to arrive at your daily operating capital. Next, multiply the daily operating capital by the number of days you think you would need before more cash comes in to arrive at a contingency amount. For example, assume that your daily operating capital requirements equals $917 per day and when you bill out there is a 90 day waiting period for funds to come back in. Under this scenario you would need $82,530 in the contingency account. Now, determine if this number feels comfortable and if not, adjust accordingly.
Step 3 Test your assumptions
At this point it is necessary to stress test the assumptions made in step two by running a forecast to see how the business will fair under:
- Average expected operations
- Worst Case Scenarios
- Best Case, high growth scenarios
There are various ways you can do this. Since every business is different, no specific set of rules apply. Nonetheless, you can try to think of scenarios where cash flow becomes effected. For example, should your account receivables take longer to pay, or you decide to expand your operation by 10% necessitating an increase in operating expenses costs.
As you can see, by taking the time to run this type of analysis you can manage your cash flow more efficiently. Your business is then in good shape to tackle slow periods, as well as take advantage of growth opportunities.
At Bay Area mastermind all members are exposed to these types of analysis and operating strategies to help them improve and maximize, their operating efficiencies. You are cordially invited to “Test Drive” a mastermind meeting today and see how you can take your business from ordinary to extraordinary. Click above and begin your Test Drive!