Cash Cushion
There is an old saying that Cash is King. I remember watching a movie once where one of characters said I believe in the Golden Rule – He who has the Gold Rules.
Cash for a business is like oxygen for us humans. Without cash a business will start to suffocate and soon die. In order to keep a business alive cash should be constantly coming in so the business can breathe. A business cannot be healthy without a steady stream of cash.
Most businesses experience some seasonality in they income and expenses. Realtors will tend to be more busy during the summer months when there are more people buying and selling their homes. Retail businesses may be busier in November and December when people are buying gifts for Christmas.
Let’s look at a retail business as an example. The business needs to increase its inventory at the end of October so that it can benefit from increased customer demand during the November and December busy season. In order to purchase the extra inventory, the business has to two options:
- Purchase inventory with existing cash
- Borrow the money
Borrowing has the benefit of enabling one to get the funds so they reap the benefits from busy season in November and December. The down side of borrowing the money is it will reduce the profit the business earns from its November & December sales.
This is where a little planning can benefit the business. Most businesses can estimate how much cash they will spend next month. A simple way to do this calculation is to look at your income statement for the last 12 months and go to the total expense line. Once you have this number, divide the total expenses by 12 and then you know what your average monthly expenses are. The benefit of using a 12 month average is it removes seasonality because you are taking into account the full year cycle.
For example if your total expenses for the last year were $1,200,000, then you know that your average monthly expenses are $100,000. Now that you have that number you should strive to build up a cash reserve for your business so that you don’t run into a cash crunch. At a minimum you should have 2 months of cash reserves. If you want to be more conservative and give your business more stability have a target of 3 months of cash reserves. This means your cash reserve target should be $200,000 – $300,000.
