Determining the Right Cash Reserves for Your Small Business: Insights from a CFO
Running out of cash can spell disaster for a business. But hoarding too much can be a waste. So, how much is just right? In this article, I tackle the crucial question most frequently asked by current and prospective clients: How much cash reserves for a small business should I have on hand?”
The Impact of the COVID Recession on Small Business Cash Reserves Planning
During the COVID recession, GDP declined by 19.2%. However, even worse was that many businesses saw their revenue reduced to zero overnight. If your business didn’t, you most likely know owners that did.
This is the reference point from which many business owners are working. The suggestions I hear from owners are often very aggressive. For instance, I work with one client whose goal is to have a minimum of one year of operating expenses in reserves.
Why the COVID Recession May Not Be the Best Benchmark for Small Business Cash Reserves Planning
As a small business CFO, I see several issues with using the COVID recession as your benchmark to determine cash reserves. First, the 19.2% reduction in ADP was the most during a recession since the Great Depression. The COVID recession was literally a once in 100 years event. Second, it’s the first recession in recorded history where healthy businesses saw revenue decrease by 100% in just a few days.
From a financial standpoint, I am glad this kick-started a conversation with small business owners about cash flow management. However, I also don’t want to see owners make decisions that would hurt the long-term prospects of their businesses.
The Importance of Cash Flow Management for Small Businesses
Many businesses fail because they don’t have enough cash to weather a financial storm. In fact, according to the SBA, the majority of business failures are a result of not having enough cash to carry on operations on a day to day basis.
The importance of having a cash cushion for businesses is undeniable. Cash reserves allow businesses to cover their bills and commitments, survive difficult times, and make sizable future expenditures. In addition, cash reserves help small businesses withstand short-term financial fluctuations, prepare for natural disasters or other disruptions, and develop more innovative policies or products.
Four Qualitative Thoughts About Determining your Cash Reserves Target
Small businesses need to consider how long it will take them to adjust to a “new” normal.
For example, if a new competitor moves across the street from your business and your revenue decreases by 20%, how long will your current business expenses remain the same? If a hurricane shuts down your business, will you keep operating expenses the same? My guess is that you would start to cut some expenses right away. The better your reporting and knowledge of your business, the fewer months of cash reserves you need.
Don’t Calculate Reserves Based on Zero Revenue.
I have heard my business owners tell me they would like “x” months of expenses on hand if their revenue goes away for a certain amount of time. However, be realistic about this. If your revenue decreased to zero for three months, would you not make any changes to your business expenses? Because of this, I discourage small businesses from simply taking three months of operating expenses to determine their cash reserves.
Cash reserves have a hidden, sometimes expensive, cost.
To stockpile cash, owners most often have to make sacrifices. And that sacrifice often comes in the way of not paying themselves or not paying down debt faster. If you are stockpiling cash instead of paying credit card debt, that is most likely costing you 15-18% each month in interest costs. If you’re not paying yourself to save cash, are you incurring more debt in your personal life or sacrificing personal investment?
Not all expenses are the same.
More than once, I have seen an owner’s back of the napkin math include three or six months of all expenses. However, most businesses have direct and indirect expenses (remember those from that accounting close long ago?). If revenue decreases, so do direct expenses. If you don’t sell as many widgets, you don’t have to buy as many. This must be taken into account when determining cash reserves.
Calculating Your Small Business’s Cash Safety Net Needs: A Step-by-Step Guide
Small businesses can take several strategies to ensure adequate cash reserves. However, below is the math I use to help my clients determine their cash reserves.
One quick point – there is no perfect cash reserve number. The target cash reserves should be a range. For instance, a business might need to keep $30,000 – $40,000 in cash reserves. Most small businesses know that expenses fluctuate. Therefore, it makes sense that target cash reserves are better off being a range instead an exact number.
Monthly Multiplier
Despite what experts tell you, there isn’t the right amount of months to aim for in your cash reserve. I have clients tell me they heard they should keep three, six, or even twelve months on hand. So I asked them where they heard this. Usually, it’s someplace with no idea about their situation, policies, business model, or expense structure.
Typically I coach my clients to keep between two and four months of applicable expenses in their reserves (more on applicable in a second).
Most of my business owner clients receive monthly cash forecasting and reports. In this case, we have a handle on the real-time pulse of the business’s cash flow. As a result, we can adjust pretty quickly. If this isn’t the case for your business, you should probably be closer to the four months than two months.
Any more than four months of reserves, I feel creates lost opportunities elsewhere. If you have more reserves then you are missing out on opportunities to invest in growth in your business. Or you are missing out on the chance to accumulate personal savings or pay down high-interest debt (the critical phrase “high interest”).
Applicable Expenses
Now that we have our monthly multiplier, how do we determine our applicable expenses? Let’s dive in using these three steps:
Determine fixed, non-adjustable costs.
These costs cannot be adjusted over the monthly multiplier period determined earlier. For instance, you are often stuck with rent whether your business makes $0 or $1 million monthly. There are a handful of expenses that you cannot adjust in the event of an emergency. COVID was a good lesson for most business owners in determining this. They should scale down utilities or employee costs but couldn’t adjust rent, insurance, property taxes, or other contractually mandatory costs.
Determine labor costs.
Next, you’ll need to group your employee into two buckets. Bucket 1 is for employees that, in an emergency, your business would only keep employed for 30 days or less. Bucket 2 are employees that your business will employ as long as you are in business. For Bucket 1, write down 1 month of payroll and taxes. For Bucket 2, write down the payroll and taxes for however long your monthly multiplier is.
All Other Costs
A significant amount of expenses fluctuate monthly and can be adjusted as needed in times of emergency. For instance, marketing, consulting, office supplies, meals & entertainment, and many more. However, a certain level of these expenses are needed to maintain the business at a certain level. This is more art than science. Once you determine this monthly number, multiply it by 40-60%.
Once you have determined these three numbers, you have your applicable expenses.
A Real-Life Calculation
Let’s put all this into a real life example. I just took one of my small business clients through the above exercise. Let me show you the math we used to come up with our cash balance.
- First, we determined our monthly multiplier. This particular client likes to err on the side of having more cash on hand than less. As a result, we used a range of two to three months.
- Determine our non-adjustable monthly costs:
- Rent: $7454 (includes property taxes)
- Monthly Insurance: $590
- Monthly Retainers: $1050
- Debt Payments: $2750
- Total: $11,844
- Nest, list all twelve of their employees on a spreadsheet. Then, we create a column for wages, taxes, benefits, and total employee costs (wages + taxes + benefits). Each one gets labeled as Bucket 1 or Bucket 2. Here are the results:
- Bucket 1: $38,400
- Bucket 2: $36,500
- Finally, we reviewed the operating statement for the past three months. We chose three months because these months were a good representation of the current state of the business. There were an average of $17,500 of other expenses each month.
Here is our final reserve calculation:
| Low | High | |
| Monthly Multiplier | 2 | 3 |
| Fixed, non-adjustable costs | $ 11,844 | $ 11,844 |
| $ 23,688 | $ 35,532 | |
| Employee Costs | ||
| Bucket 1 | $ 38,400 | $ 38,400 |
| Bucket 2 (monthly) | $ 36,500 | $ 36,500 |
| $ 73,000 | $ 109,500 | |
| Other Operating Costs | $ 17,500 | $ 17,500 |
| $ 35,000 | $ 52,500 | |
| Cash Reserve Target | $ 170,088 | $ 235,932 |
For this business, we determined an adequate cash reserve range was $170,088 to $235,932.
Your Small Business’ Liquidity Management: Tips and Strategies
There are a couple of considerations an owner should keep in mind.
How Often Should You Re-Evaluate Your Cash Reserves Target?
I often get a question about how often this should be computed. My answer is not every month and more often than twice per year. Determining how often this should be computed involves a blend of skill and expertise. A business will want to compute this as it continues to evolve. For most businesses, the operations change every 3-6 months. As a result, this should be re-examined at the same frequency.
Including Owner Pay and Debt Payments in Your Cash Reserves Calculation
Second, many owners forget that there are cash disbursements that are not included in their income statements. Many owners make the mistake of looking at their operating expenses and determining reserves strictly on those. However, there are often two significant “expenses” that are not on the income statement. Those expenses are owners’ pay (often distributions) and debt payments on term loans. Make sure to include those in your calculation.
Maximizing Your Cash Reserves Earnings: Tips for Finding the Right Business Savings Account
Another consideration is where to keep these funds. As of writing this article, business savings accounts are paying between 1-3% interest. Shop around for one of these. It’s an easy way for the business to earn an extra few thousand dollars each year. In some instances, a cash reserve fund might not need to be in a business account. An owner could distribute these funds and build a personal reserve elsewhere that they could access if needed.
Creating an Emergency Fund Plan: When and How to Use Your Cash Reserves
Lastly, when should you use cash reserves as an emergency fund? My dad used to ask me, “what are you saving all that money for?”. I would reply, “It’s my savings.” Years later, I understood what he was asking – what are your savings goals and when is it OK to use that money? Many owners need to “allow” themselves to access these funds in certain circumstances. It is helpful for an owner to write out the 5-10 circumstances they will allow themselves to draw on these funds. That way, when a circumstance arises they will feel better using these funds.
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