Every small business owner knows that cash is king. Keeping cash flowing is critical to the survival and eventual success of your business. So, yeah, cash flow—as documented in your cash flow statement—is very important for a business. But wait…is there such a thing as having too much cash? Believe it or not, there is such a thing, and many small business owners don’t even know about it. Do you? Do you have too much cash in your business? To figure that out, let’s get into the numbers.
What metrics should you consider?
There are a lot of metrics that an investor considers when valuing a small business. But one of these metrics weighs heavier than most: return on assets.
It’s a simple calculation. You just look at a company’s net income over its average assets at the beginning and end of a period. Then, take a step back and say to yourself: Is my money working better here than it could be somewhere else?
Start with the return on assets calculation.
Doing the return on assets calculation once or twice a year will help determine just how well your company is using its capital. It also can tell a potential investor whether or not there will be a greater return by buying these assets or by buying something else with a more reliable revenue stream, like a treasury bill or government bond.
Having too much cash negatively impacts this metric in a big away. Just think about it: the more cash you have, the higher the denominator of the calculation (your average assets) and therefore the lower return on those assets. Too much cash tells the world—and you—that you’re not managing your resources as well as you could. Investors don’t want that. You don’t want that.
Diversify your small business’s assets.
There’s another big reason to not keep too much cash in your business and that reason can be summarized with one word: diversity. You don’t want to keep all of your eggs in one basket. You want to diversify your business assets.
You should have some money in long-term investments, some in more liquid accounts, and some in capital assets like equipment or property. You should be pulling money out of your business and allocating for your own retirement, your kids’ college savings, rainy day funds, and personal investments. If anything befalls your company—a lawsuit, a dishonest bookkeeper, a big competitor opening up next door—you don’t want to have all of your cash exposed. Move it out and spread it around.
What is the right amount of cash to keep in your business?
That answer really depends on the business. If you’re running a seasonal business, like an ice cream store near a New Jersey beach or a landscaping company in Ohio, then you’ll need more money at the beginning of the season to cover outlays for materials, inventory, and labor.
The same goes for businesses that are subject to the ebbs and flows of their customers. A college pizza shop will need less cash during the summer months. A business selling novelties and crafts may need more capital before the holiday season.
But let’s cut to the chase. How much cash should a typical business keep on hand? My advice: at least six months of operating cash.
By operating cash, I mean all the cash you use to run your business: rent, utilities, recurring labor, recurring purchases, etc. You can pull these numbers from your income statement. Look at it over both a six- and 12-month period and then take an average six months. Then target that amount.
Three ways you’re protected by having this cash.
Once you hit your goal of having six months’ operating cash on hand, three things will happen:
The first is that you’ll be much better prepared for any economic downturn. Whether a recession happens next month or next year, one thing’s for sure: Small businesses with sufficient cash are the ones who not only weather the storm better, but survive. Managing your cash flow isn’t about the month to month. It’s about the longer game. When things are going great and the cash is rolling in, make sure you’re socking enough away to hit that six-month goal. You won’t regret it when the flow dries up a little in a downturn.
Second, you’re going to make better business decisions. You’ll negotiate better. You won’t be as desperate for deals. You’ll be able to take advantage of the really good deals, as opposed to those that aren’t in such as strong cash position. You’ll also be more confident with customers, particularly those not-so-great customers who try to take too much. You’ll always need customers, but some you won’t need as much when you have the cash in the bank to just say no, thank you, this is just not a good deal for me.
Finally, and this is most important, you’re going to have a different mindset. Sure, you’ll be more confident with cash in the bank. But whatever excess cash you’ve generated will hopefully be distributed to you personally so it’s out of sight, out of mind. You’ll be running your business as lean and mean as possible. You won’t overpay or spend frivolously because you won’t have the cash to do so—at least not in the business. You’ll always behave as if this is all the cash you’ve got, and make decisions based on that.
So yes, having cash in the bank (or somewhere else that’s easily accessible and liquid) is definitely a good thing. But having too much cash can have the opposite effect. My advice: Keep at least six months’ operating cash in your business (or a little more or less) and then deploy the rest of it more intelligently somewhere else.
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