If you’re going to stay in business you’re going to hear many quotes about cash.  Two of the most popular quotes are: “Revenue is vanity, profit is sanity but cash is king,” and, “The number one reason businesses fail is a lack of cash”.

Cash, as in “cold” and “hard,” is the lifeblood of your business.  If you’ve been successful in managing your business, the business has started to generate more cash than required to keep your business operating.  The extra cash is always great to have but the questions then turns to how much cash you should keep in your business.

Is there a right amount of cash to keep in the business?

What is Cash?

Let’s first start with a definition of cash.

Cash is being used here to define the amounts in checking savings, money market funds and certificates of deposit (CDs) in the business.  It is the most “liquid” asset of the business, meaning it is the most easily accessible asset.  Some businesses may keep physical cash on hand in the form of greenbacks but most businesses, for security reasons, keep the cash in a form easily accessible but electronic.  Cash is held at a financial institution and can be accessed via electronic funds transfer, check or a transfer within the financial institution.  By its very nature, cash is accessible and available.

Cash maintains a fairly static value, meaning there won’t be any wild swings in the price of your cash from day to day.  In politically stable countries, the value of cash changes little to not at all from day to day and possibly year to year.

Despite not changing value from day to day, cash usually earns interest in a bank account or money market fund (the brokerage version for cash).  The amount of interest cash earns is generally less than the rate of inflation.  For example, if prices across the economy are rising at a 3% rate most bank accounts will pay less than 3% creating a sort of disincentive to keep money parked in cash long term.

Short Term Cash Helps to Achieve Long Term Vision

Stockpiling cash in a bank account long term is not a primary objective for any business.  The business doesn’t exist to pad a bank account, it exists to serve clients and provide them with useful goods or services, something that solves their problems.

Keeping money in cash effectively stops the flow of the product lifecycle for the business.  Instead of purchasing inventory or otherwise investing in the company, the money is diverted to a cash account as a “parking lot” of sorts.

In addition to not being able to invest in your business, cash has a very low return on investment.  Banks are currently touting their “high interest savings accounts” with banners outside branches of offers of 2% interest in a CD.  Using the rule of 72, this money will require 36 years to double!  Hardly a get rich quick scheme!

But cash isn’t meant to get rich.  Even in the days of double-digit interest rates, rates for cash were never meant to entice investors to make a fortune or “swing for the fences” by locking up their money in a CD.

Cash Provides Stability to the Business

Cash is meant to provide stability to a business, a holding place for the money as it runs its course between investing and returning with the sale of the product.  It serves as an insurance policy of sorts if things really get bad.

The question is, how do you balance this tension between cash on hand and investing that cash in the future growth of the company?  After all, placing cash in a savings account reduces the money that can be spent to hire, purchase inventory or develop new products.  It effectively limits how much money the business will earn.  More cash on hand = less future profit.

What could possibly be the incentive to save money in your business?

Quality vs. Quantity

There are great books written on this question.  Investors have spent lifetimes studying cash flow and cash management.  There are theories that say a multiple of your expenses such as three to six months should be kept in cash.  This suggested amount will smooth out the bumps and hiccups and should give you leeway to avoid a cash crunch should your business experience any “softness” in the economy.

But this doesn’t work across industries.  Service provides and “asset light” industries relying primarily on skilled labor don’t need to worry about large inventory investments or capital expenditure needs.  Surely the three to six months can’t be translated to a capital intensive business with major asset purchases every few years.

The number of months of cash the company needs is different depending on growth plans, operating lines and market expectations for a business in a given economy.  That’s why this question is so difficult to answer.

Here are three considerations for determining how much cash to keep in your business:

1. Maintain enough to satisfy your covenants

If you have a commercial lending relationship, it is likely there are financial stipulations (aka covenants) that you must maintain.  Many of these are related to the most important metrics for banks, which help to keep your bank out of trouble and your company well financed.

One of the most popular metrics is concerning the current ratio.  The current ratio is a measure of liquidity, or how easily your company can meet its obligations when they come due, and is found by dividing current asset by current liabilities.  Banks have guidelines for this and it may be 1.1 to 1 and often times they will put this language into the loan documents.  If they have, this is a great guideline especially since there can be ramifications if you are “out of covenant”/non-compliant.

2. Consider your short-term borrowing needs

A conversation about keeping cash in a business assumes your business is not using an operating line or line of credit.  An operating line is a loan the bank gives you to purchase product that will be turned around quickly, usually inventory, and the proceeds are then used to pay down the line.  In theory it goes up when the raw material is purchased and goes down when it is sold.

If you have a line of credit, you are paying the bank to use their money for a short time before repaying the loan.  It makes little sense to keep money in cash if you could just use that money to pay off the line.  The interest rate difference will not be in your favor between the cash you are saving and the interest you are paying on the loan balance.

If you do have an operating loan and are relying on a financial institution, do remember that banks decide to close out/cancel lines of credit when their loan committees get nervous and need to protect their institution.  This thought should always be in the back of your mind especially when growing.  Look for ways to protect yourself because we all know the economy is dynamic and will change, not static.

3. Have enough cash on hand so you sleep well at night

If you pass sleepless nights wondering if you’ll make payroll or be able to pay the bank you most likely don’t have enough cash.

How do you measure enough?

As mentioned, it varies dramatically depending on who you are, the industry and economic cycle in which you operate.  Some love the insurance cash provides and some are more comfortable with risk and ready to invest cash as soon as it comes in.  Whether you have three months expenses on hand in cash or twenty-four, what matters is the quality of your life.

And the quality of sleep.

Late in an economic cycle, like we are here in 2019, you may want to be more defensive and build up a cash reserve for your future sleep habits.  Use the cash as an insurance policy to ward off the potential bad dreams that could play out.

Cash Is Like Insurance; You Want To Get It When You Don’t Need It.

With every extra month of cash savings provides an extra month you have to deal with the shortage of cash.  The extra months afford you and your employees time to strategize and not merely react.  Use the bank account to “purchase” future sanity, mental health and decreased stress.  The savings will assist you with these goals.

Cash is often thought of as “trash”, an asset not earning money for the business, but it is better thought of as an insurance policy without a premium.  Just like insurance, the needs for cash vary across businesses.  The important ideas are to know your industry, personal comfort level and the desired amount of cash to maintain.  Then, make a plan to save and keep cash at that level.