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CASHOS WEEK 5: THE FORMULA FOR CASH RESERVES THAT COULD SAVE YOUR BUSINESS
THE FORMULA FOR CASH RESERVES THAT COULD SAVE YOUR BUSINESSHave you ever been in the position where you didn’t have enough money for payroll the next day? I remember the one time I got that call. It was early in the morning. Over the weekend I’d talked to the owner and let them know the deposit that we were expecting before the weekend hadn’t come, but I’d been assured it’d deposit in our account on Monday. Monday morning it wasn’t there, so we called the bank and customer. We were assured before the end of the day it’d be there. Late afternoon it showed up and breathed a sigh of relief. But the next morning, the CEO woke up and checked the bank and it was gone. What happened? This was the call I woke up to. Turns out it was just a bank issue, but for three hours my heart never stopped racing. This is a call you never want to get or a discussion you never want to have. But, the number one reason small businesses fail is cash flow. Yet 34% of businesses have less than one month of cash on hand. What gives? And despite these cash issues, no one seeming to know the answer to “how much cash should I keep on hand,” and there is very little education on this. We see 3-6 months, but that really comes from personal finance. So today, we’re going to dig into:
THE 3 BUCKETS OF CASHI mentioned these three buckets in The 3 Jobs of Cash, but now we’re getting practical and start adding numbers.
Operating cash is just the cash going in and out of your account each week. It’s not for emergencies, big strategic bets, or anything past the next 30 days. The amount in this account will vary based on the ebbs and flow of business, but the idea is that all cash filters through this account. Then, based on the rules we’ll talk about later, cash gets transferred to other accounts. Typically, you’ll do this transfer once a month, but it can be done as much as weekly. Reserve cash is the cash you keep to protect from uncertainty. We split this into two buckets:
Many like to put this in separate accounts and I’m good if you want to do this. But it’s not required and all a part of the “reserve” we want to set aside. EMERGENCY FUNDSTo determine how much money we want in our emergency funds, I like to look at three different numbers
Biggest cash negative period over the last 3 years Look at your month-by-month Statement of Cash Flows or Income Statement for consecutive months of losses or negative cash flows. For seasonal businesses that have periods where sales do not support overhead, you’ll see the same patterns show up year over year. Monthly Operating Spend Operating spend is the spend required to operate the business day to day. Notice this doesn’t include Cost of Goods Sold or other non-recurring expenses in Other Income/Expense. We want to look at this spend throughout the year and find the period when the average spend peaks. Whether we use a 3 month, 6 month, or 12 month average depends on a personal preference. We also can look at two different variations of this number:
Barebones is typically say what you need to “keep the lights on.” You can also say anything you have long-term contracts on. For example, I often look at, rent, utilities, and software/subscriptions required to operate. Look through your Income Statement and pull out what you think fits this profile and move on. Payroll only is what it sounds like. You can typically look at current payroll, but if you have seasonal fluctuations, look for those as well. Monthly Debt Service Look at your Balance Sheet debt and the associated monthly payments. Look for any looming term changes, but otherwise this is pretty simple. One thing to note: make sure you include TOTAL payment. This will be what is applied to the debt and interest. CALCULATING YOUR MONTHLY BURNNow that you have these numbers, you can choose which operating expense number you want to use and whether or not to include debt payments in your burn calculation. I typically encourage looking at the one month average of:
Payroll is for the catastrophic event while #2 is the more “normal” safety net. Now that we know our one month burn, next we determine how many months of cash we want to keep on hand. The problem is, business finances aren’t as simple as personal finances. So I put together a formula to help us solve this. THE EMERGENCY RESERVE FORMULAWe want to consider the following variables:
Start at the left and move to the right, adding or subtracting based on which of each element most identifies with your business. Now multiply the number of months by your preferred monthly burn. This, compared to your highest negative cash flow period, will give you a good range to start with and adjust as you see fit. We want to make sure the cash reserve is greater than our negative cash flow period, as this is a part of “normal business.” When planning for a cash reserve, you’re planning for 3 things:
For 2 & 3, there are specific purposes. We want to keep enough cash on hand so we don’t have to:
As long as you have enough cash for your liking in these situations PLUS the peace of mind that allows you to sleep at night, we’ve achieved our goals. You could have two identical businesses make a different decision here based on the owners risk preference and that’s fine. TAX RESERVEWhile your tax reserve is part of reserve money, tax reserve should be over and above your emergency reserve. Too many business owners don’t set aside money for taxes. And when you grow, it makes it worse. Now you owe more and likely set none of it aside. I’m not a tax professional, so lean on them to know what to expect you’ll ultimately owe. But that doesn’t prelude you from setting up systems in your business. I like to tell business owners to pick a percentage of cash to set aside each month based on their Net Income or EBITDA. I typically look for around the effective tax rate, but this is really going depend on your business tax structure and personal tax situation. STRATEGIC CASHStrategic cash is the cash you need to grow your business. While you’ll often take on debt to do this, having some additional cash in this bucket gives you more flexibility. This is too big a topic for this issue, so we’ll tackle this next week along with establishing cash rules. IT’S NEVER SIMPLEWe want to “label” our cash in spreadsheets, on the chart of accounts, or by opening different bank accounts. It’s your preference how you approach it, but don’t overcomplicate it. Your reserve cash need should and would change every month because your business is changing. Setting up a system to automatically calculate that need monthly is important to make sure the number changes with your business. Even with the best reserve planning, you’re still not immune to the invisible weight pulling on your cash. These “unseen forces” aren’t captured in the reserve formula, but they still drain liquidity and can leave you blindsided if you don’t account for them in your forecasts, spending rhythms, or cash rules. Some of these would be:
This makes each business, and each cash reserve formula, unique to you. If you need help with this, we do this at Bison CFO and we’d love to help. NEXT STEPSWhat’s next is clear: calculate your reserve cash need. We’ve put together this downloadable sheet: Click here to get it Thanks for reading–see you next week, Work with meNeed more than this newsletter? You may not know, I have other ways we can work together. Check them out:
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