Having enough cash on hand will ensure your business can stay afloat and survive even during difficult economic times. However, just how much cash should a business have on hand? Read on to learn how to calculate how much cash a company needs.
What Is Cash on Hand?
Cash on hand refers to funds you have set aside for emergencies and other unexpected expenses. Many businesses keep money on hand in savings accounts, though choosing the proper high-yield savings account can help you get more out of your money. However, cash on hand can also refer to assets that you can quickly exchange for cash.
In either case, cash on hand shouldn’t be invested into stocks or high-risk investment opportunities. That’s why it’s called “cash” on hand.
Why Your Business Needs Cash on Hand
Having cash on hand is critical for a few reasons. It will help your business keep operating even if you go through a few months of no profits, which can happen due to new competition, economic downturns, and sudden losses.
The economy can take a downturn at any given time, and cash on hand gives you time to get through it or help you figure out strategies to overcome it. You’ll be able to keep buying goods, paying employees, and handling your other expenses.
In addition, cash on hand can help you in emergencies, such as if a machine breaks and you need to buy a new one, a fire breaks out in your office, and other potential emergencies.
Finally, cash on hand makes it easy to expand and scale your business. You’ll be able to invest in new projects, features, services, and equipment without needing to save up first, allowing you to get ahead of the competition.
What Is the Average Cash on Hand for Small Businesses?
The rule of thumb for cash on hand for small businesses is 3-6 months of operating expenses. That includes:
- Cost of goods
How to Calculate How Much Cash a Company Needs
Every business is different. Some businesses need at least six months of expenses in cash on hand, while others need only three or four.
So, how can you know how much cash your business needs?
The first thing to figure out is what your costs are every month. For some businesses, this is easy – just look at your expenses for the past 6 months, add them together, and divide that number by six.
However, it gets a bit trickier if you have a seasonal business. For example, if you sell Christmas trees, you can’t calculate your expenses from February to July to determine your monthly expenses.
Similarly, if your business is new, you’ll have to deduct startup expenses that only applied the first few months. The same applies to one-time expenses like building renovations.
The next factor to consider is the percentage of those expenses that aren’t truly necessary. If you can cut expenses and still operate on a profit (or without a loss), those expenses don’t need to be included in your monthly total. If an emergency arises, and you need to rely on your cash reserves to keep you afloat, you can cut those expenses.
For example, you may be able to lay off some workers and still operate at a decent level of productivity.
There are other factors you must take into account as well.
If your business has excellent credit and you can get a quick retail store business loan with low-interest rates at any time, you might not need as much cash in hand. If you have assets you can quickly sell, the same applies. In addition to the liquidity of your assets, consider whether they are appreciating or depreciating.
Similarly, if you can get a merchant cash advance, you can take the advance into the equation when determining the ideal cash-on-hand amount for you. (Read: How does a merchant cash advance work?)
If your cash flow forecast is pretty healthy for the next couple of months, you may also be able to get away with less cash in hand. Nevertheless, don’t rely on that – you need to be conservative when forecasting future cash flow and consider the worst-case scenario.
Industry forecasts can also help, but if Covid-19 has taught us anything, it’s that we can never know what will happen.
Finally, the nature of your business is significant as well. If you operate a currency exchange office, you need more cash on hand than if you offer HVAC repair services.
Cash Reserve Formula for Small Business
The typical cash reserve formula for small businesses is as follows:
(Total monthly expenses) – (discretionary spending) x (number of months) = cash on hand
Having too much cash on hand can also be detrimental.
Have you ever wondered, “Would it be better for the business to have a lot of cash on hand? Why or why not?”
Depending on the nature of your business and the other factors I discussed above, having more than six months of expenses in cash on hand can sometimes be okay. However, having too much cash can also cause you to miss out on more profitable business investments and expansion opportunities.
Besides, you may be able to earn higher interest rates by putting the extra money in less liquid assets, like stocks or bonds.
Furthermore, some business owners have difficulty sticking to a budget when they have too much cash on hand, becoming reckless in their expenditures. Not only that, but having too much cash in the bank can make your losses greater if you end up being the victim of business identity theft or hacking.
If you don’t have any cash on hand, you may struggle if you have a few slow months. Use the tips provided above to learn how much cash on hand you should keep in the bank. If you’re interested in learning more budget and cash flow tips, check out these hidden secrets in small business bookkeeping.