Cash is like fuel for your business. You need it to keep your business running. But how much cash should a business have on hand?
Continue reading to learn how much cash your business needs.
What is cash on hand?
It’s the money a business has in cash assets or assets easily converted to cash.
Cash on hand can include money held in:
- Cash registers and change stores
- Business safes
- Business checking accounts
- Business savings accounts
- Investments you can sell in 90 days or less
Cash on hand, in general, excludes the value of:
- Long-term investments
- Goods held in stock
Why is it essential to have adequate cash on hand?
Keeping the right amount of cash on hand is useful in a few key ways:
- It lets you keep paying your bills. You need adequate reserves to meet financial commitments to employees, customers and vendors.
- It’s useful for business valuation. It helps you and potential financiers assess the value of your business for tax purposes, a loan or a sale.
- It helps you weather good and bad business cycles.
- It covers your costs when you launch a new business and aren’t making any money.
- It keeps you afloat in a low-demand season with little or no sales.
- It helps during the transition from an old to a new product line.
- It can help you make a sizeable future expenditure.
- It can prepare your business in the event of a natural disaster that keeps you from making revenue.
How to figure how much cash to keep on hand
Now, you see how vital it is for your business to have an ample cash reserve. But you might be asking, “How much cash should a business have on hand?”
In general, you want to keep cash reserves equal to three to six months of expenses. The idea is that these funds should be enough to meet your obligations even in months when you have no cash inflow.
To start, analyze the expenses listed on an income statement. Then factor in both overhead costs (e.g., rent, utilities) and production costs like cost of goods sold.
Run a year-round business with stable monthly expenses? Figure the average monthly costs for the last twelve months. Multiply the result by three to six to get a sense of how much cash on hand your business needs. So if you have $5,000 in average monthly expenses, aim for a cash reserve of between $15,000 and $30,000.
But what happens if you run a seasonal business with all expenses concentrated in a few months? Aim to cover one high-expense month and a couple of months with average costs. Say you incur $10,000 in expenses in your highest-expense month.
The average expense of the other months is $7,000. To calculate a three-month cash reserve. Multiply 7,000 by two and then add $10,000 to get $24,000.
How many months of cash on hand are right for my business?
Whether you go with the three- or six-month rule (or somewhere between) depends on:
- Your business operations. Do you run a year-round or seasonal basis? A year-round business with stable expenses can often keep more in cash reserves. A seasonal business may find it easier to keep less cash on hand.
- Your business stage. Is your business new or established? It’s often harder for a fledgling firm to shore up its cash reserves than it is for a long-running business.
- Your expectations for growth. A company in rapid growth often needs more cash to meet its growing commitments.
- Your future expenditures. Do you have any big purchases planned over the next 12 to 24 months? If so, you may need to keep more in reserves as the buy may consume a large chunk of cash.
- Your confidence in customers or clients. How confident are you that the clients or customers you have today will be there tomorrow? Can your business take the hit if you lose one or more of them? Your answer should dictate how many months of cash you keep on hand.