Your business needs cash. Cash is what keeps your company in operation and enables it to grow, so you should know how much cash your business needs to survive. Although many people think the answer is linked solely to operating expenses, this isn’t the case.
There is no single factor that determines how much cash every business needs to have on hand. Somewhere between 3-6 months of operating expenses is a good baseline to start from, but there’s more to it than that.
Here are some factors that determine how much cash your business needs.
1. Your income
The source of your income helps determine if you need more or less cash. If your income isn’t highly diversified—that is, if the majority of your income comes from one or two main clients—you’ll need to have more cash on hand. That’s because if your main client leaves you, you’ll suddenly find yourself with significantly less money coming in.
If your income is diversified, you’ll be better able to withstand losing a client, so you’ll need less cash available. But if the majority of your income comes from one source, you need to be prepared to have little income if they leave.
Likewise if your business has investors, they could request their money back at any point. You’ll need to cover that.
2. Your expenses
Businesses typically have fixed overhead expenses and variable expenses related to the cost of goods sold. You need to know how each of these affect you over a few months so you can prepare to cover them.
Look at your financial statements for a period of at least six months, and make sure you account for busy seasons and slow seasons. See where your money is spent and how much you need on average to cover those expenditures.
3. Your assets
Liquidity refers to how easily your assets can be turned into cash. Stocks and bonds can easily be converted to cash, whereas property and equipment often take time to sell and are therefore less liquid.
The more liquid your assets are, the less cash you’ll need. If you don’t have a lot of liquid assets, you’ll want more cash accessible.
4. Your spending situation
Your spending situation is based on how much of your expenditures are mandatory and how much are discretionary—that is, you can operate without those expenses. If you have a high proportion of mandatory expenses, you’ll need cash to cover them if times get tough.
Discretionary expenses can be cut without significantly affecting business, saving you money or freeing it up for mandatory expenses. If you spend $5,000 a month on employee meals, you can easily save that money by not going out for a few months.
The more rigid your spending situation is, the more cash you’ll need on hand.
Final thoughts
A final important factor is opportunity cost. Money covers emergencies and downtimes, but keeping too much money in the bank means you’re missing out on investments that could build your wealth and quickly be converted into cash. Talking to a financial expert can help you understand your opportunity cost and whether you need more or less cash available to you.
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