There’s an old saying that cash is king – and it’s certainly very important to the daily functioning and ongoing growth of almost every business. From paying your staff and suppliers to investing in your future, the amount of cash you have to hand in terms of your business finance has an enormous impact on what your business can and cannot do.
Run out of cash and your bills and people will go unpaid, and it won’t be long before you’re suffering cashflow problems, facing penalty charges, legal action or even the imminent threat of becoming insolvent. But keeping too much cash on hand has its disadvantages too. Retain too much cash in the business, instead of investing in your future, and you’ll restrict your ability to grow – and give your competitors the edge. So how much cash do you really need?
One size doesn’t fit all
The simple answer is that there’s no simple answer. No two businesses are the same, as every business uses cash in different ways. Those that sell high volumes of low-profit goods, for example, will need a lot more cash on hand than those selling low volumes of high-margin products.
As a result, the only way to work out how much cash you need is to consider your expenditure. Evaluating your outgoings for the last few months should be sufficient, particularly if you haven’t experienced significant growth or contraction. The amount you spend each month represents your gross burn rate, so a business earning an average of $50,000 a month but spending around $30,000 would have a gross burn rate of $30,000. Your net burn rate, meanwhile, would be $20,000, indicating that you typically earn $20,000 a month more than you spend. The challenge is to decide how much of this to keep in cash and how much to invest in growth.
How not to feel the burn
The key rule of cash management is that you must be able to meet your outgoings even if clients pay late or there is a downturn in business. To avoid a negative burn rate, you should establish a contingency fund with enough cash to cover three to six months’ expenditure. A large contingency fund will cushion your business against a drop in cash flow, so a major customer going bankrupt or the loss of a key account will not derail you. But how should you calculate how much to keep.
First, you need to divide your gross burn rate into two types of costs. Production costs relate to creating your goods and services, and scale up or down depending upon your sales volume. In contrast, overhead costs are fixed and must be met even if your business has zero sales in a given month. These costs can include rent, salaries, loan repayments and business rates.
A good contingency fund should enable you to cover your overhead costs for several months, and if you’re enjoying a particularly profitable period you may be able to build up the fund in a single month.
What about business development?
When your business is doing well, you could find yourself with both a substantial contingency fund and a significant amount of spare cash. How you spend this profit will have enormous impact on your future stability and growth. Remove the profits as salary or dividends and your growth potential will be significantly removed – businesses need money to expand.
You should therefore channel these funds into investment for growth, which could include stepping up your advertising, investing in new equipment or hiring experienced, capable and talented people. Once this investment has resulted in additional growth, you should recalculate your gross and net burn rates and again reinvest excess funds, creating a virtuous circle.
Emergencies can happen – and frequently do
Finally, don’t fall into the trap of assuming that steady and significant business growth means you will never hit hard times. If you don’t keep an eye on your contingency fund, a single setback could mean you face a cash flow crisis in a matter of weeks. Have a contingency sufficient to cover three to six months’ expenditure and keep investing, and you should be able to face the future with confidence.