One financial decision that a lot of entrepreneurs seem to struggle with is the question of how much cash reserves their business should maintain.
Hold too little cash and you could find yourself in serious trouble if your business takes a turn for the worse. Hold too much at today’s rates and that may prevent you from investing to your company’s growth to your full capacity.
When it comes to personal finances, a generally accepted rule of thumb is that we should all have enough cash on hand to cover six months of expenses in case of emergency. While I’ve heard this same advice given to small business owners, in reality there is no one-size-fits-all approach that applies to everyone’s business.
Instead, the answer requires an assessment of where your company is in its lifecycle, as well as a look at some quantitative factors and a bit of worst-case scenario planning.
If you’ve got an early-stage company without much revenue, then it probably isn’t practical or sensible to stash away enough cash to cover six months or more of operating expenses. But it’s definitely smart to start planning for the future and adopting a prudent approach to cash management.
That’s why startups should consider setting aside a small portion of their revenues, five to 10 percent, in a reserve account and then re-assessing their needs as the company grows.
Once you’re past the start-up stage and have a consistent revenue stream, there are a few steps you should take to help determine the right size for your cash reserves:
While there is no magic number that you’re looking for, you should have enough to cover at least a few months, and if your business is seasonal or depends on big orders that can be few and far between, you’re definitely going to want a larger reserve.
In addition to performing the preceding quantitative exercise, it’s also prudent to ask what-if questions that can help you prepare for a reversal of fortune. Questions like, "What if I lose my best customer or my top-producing salesperson?" In order to come up with actionable results, try to assign a dollar value to each scenario as well as the probability that it will occur.
For example, if losing your top producer would cost you $100,000 and there is a 10% chance that he will leave this year based on your company's turnover history, then you should set aside $10,000 in cash to cover this possibility.
Hopefully by doing a bit of financial analysis and some sensible planning for the future, you’ll come up with a cash reserve that's big enough to see you through the tough times—but not too big to keep you from investing in your growth.