Managing Cash Flow Complexities – Part 1: How Much Cash?

Recently I had a conversation with a business owner about the amount of cash that a small business should keep on hand.  The business owner had been told by a couple of reputable sources that the amount should be 2-3 times their monthly operating expenses, and he had also heard that this amount should be as high as six times their monthly operating expenses.

The problem with simple answers like this is that they don’t address a very complex question.  Each business is unique and has very individualized cash flow needs.  Sometimes simple answers like this can be detrimental to the business.

In this particular instance, the business had poor cash flow even though it had been business for many years.  However, the business owner ended up following the advice that had been given to him and borrowed the maximum on the company’s credit line all year long in order to maintain this high level of cash on its balance sheet.  This was creating three unintended consequences for this company:

  1. Most banks want to see a credit line used for short-term seasonal needs, or fluctuations up and down as receivables rise and fall.   As such, most banks want to see a credit line “rested” during the year (e.g. paid down to zero two or more times per year for a period anywhere from a couple of weeks to a month).  When a small company is fully borrowed on a credit line for the entire year, this can give the banker reason to worry about the current health of the business, the business acumen of management, and/or the future risks related to cash flow.
  2. In reality, the business was not reserving real cash for future emergencies, but instead it was borrowing on a credit line to artificially increase the cash levels.  The interest expense paid on these borrowings was a substantial expense to the Company and, because the money was deposited in a non-interest-bearing bank account, there were no interest earnings to offset the interest expense.  If they had let the credit line stay at zero, instead of borrowing to put money in the bank account, they would have saved this considerable expense.
  3. The high level of cash on the financial reports usually gives a false sense of security.  Unfortunately a lot of companies end up with the reality that when times appear to be good and cash flow levels appear to be high, they spend more for unnecessary or extravagant things.  However, when cash flows are extremely tight, managers and owners usually buckle down and stick to budgets and spend very wisely.  At an extreme, a very high level of cash may also send out indications to outside owners/investors that the Company is not using its cash resources as effectively as possible to reinvest, grow the company, or make distributions to owners.

So, should a small company maintain cash on hand at a level of 2 to 6 months of operating expenses?  The answer, in my opinion, is it depends on many factors, that include:

  • Years in business
  • Relationship with bank and the likelihood for a credit line increase and/or renewal
  • Projected growth
  • Projected capital needs
  • Expected changes in receivables
  • Projected profitability and risk associated with those projections
  • Reliability of systems to monitor and project cash flows based on known factors and historical trends, and
  • Other factors.

In today’s business environment, the answer to many complex business questions are usually not based on a simple formula, or short answers.  There is no doubt that cash flow is one of the main factors involved in determining whether a business thrives, barely survives, or dies.  The complexities of your business…properly analyzed and understood…will help you determine the right answer for your organization on how much cash you will need.

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