How Much Cash Does Your Business Really Need to be Prepared for the Worst?
The ability of your company to successfully navigate unexpected challenges relies heavily on your ability as a business owner to think ahead and take preemptive action before the worst can happen. One of the most important ways to ensure your business is prepared for anything is by keeping a steady reserve of cash — or Minimum Cash Balance — on hand at all times.
Think of a minimum cash balance as your company’s life preserver in the event of complete disaster. It’s what will keep your business afloat when you’re hit with unexpected business challenges like dips in revenue, bottlenecks in cash flow, or unpredictable circumstances that blindside you, such as what we experienced in 2020.
You need adequate cash reserves to pay for the purchase of goods, payment of payroll and operating expenses, and shipment of goods to the customers while you are waiting for customers to pay.
For many business owners, the coronavirus pandemic was a major eye-opener. In a matter of days, many business owners watched their revenue disappear while expenses like operating costs and payroll piled up. Without adequate cash reserves, many of those companies were forced to close their doors for good. To increase the chances that you’re protected during the next business surprise, take steps now to make sure that your minimum cash balance is adequate.
How Much Should Your Minimum Cash Balance Be?
If you’re not sure how much cash you should have on reserve — don’t worry, you’re not alone.
Many women business owners aren’t sure how much cash they should have on hand at any given time. Do you need enough to cover one month of expenses? Or 6 months of expenses? How much is enough?
Luckily, there’s a simple way to calculate exactly how much your minimum cash balance should be, but there’s one crucial factor you need to consider first — your operating cycle.
Understanding Your Operating Cycle
When considering how much cash to keep in reserve, many women entrepreneurs look only at their monthly expenses. But having a minimum cash balance to cover just one month of expenses can leave you short.
What you should be looking at instead is your operating cycle, which is the period of time between when you start to spend money to create the goods and services you’re selling and when you’re finally paid. In many cases, this cycle is longer than one month.
For example, let’s say you have a business that manufactures and sells mechanical items. First, you purchase the components from various vendors. Then, your team assembles the items, during which time you are paying wages and/or salaries. You then sell the items on accounts receivables and wait for the customers to pay their invoices. Although your invoicing terms say payment is due within 30 days, in reality you may actually wait longer, such as an average of 37 days.
Based on the total period starting from the day you start buying components until the day you finally receive payment, your operating cycle could be 73 days. This would mean you need a minimum cash balance to pay 73 days of expenses.
So, before you set a minimum cash balance, always take the time to research and understand the length of your operating cycle. Then be sure to keep enough cash reserve available to float you through an entire cycle.
Calculating Your Current Working Capital
Now that you know how much cash your business should have on hand, compare that number to the amount of working capital you currently have. Although some fluctuation from week to week or month to month is normal, you generally want to ensure you have the minimum cash balance available most of the time.
To calculate your current working capital, first tally up your current assets. Current assets are cash or anything that could be converted into cash
within a month to pay current liabilities. Current assets include cash and cash equivalents, accounts receivables and inventory. Then subtract your current liabilities — the expenses and bills that are due within the operating cycle.
If your calculations reveal that you don’t have enough working capital to cover your operating cycle, it’s time to build up your cash reserves and/or get access to a line of credit.
Make Sure Your Business Is Always Two Steps Ahead
Maintaining a minimum cash balance is just one of many ways you can make sure your business is prepared for the unexpected.
If you want more help calculating your ideal minimum cash balance – plus tips and strategies you can use to boost your balance – let’s chat!
Book a 45-minute, no-obligation Financial Strategies and Solutions Session with one of our highly trained virtual CFOs.