Here at the Numbers Coach, we have often discussed the importance of businesses establishing cash reserves (see this article for more details on how and why). Having a cash reserve gives a business owner a good chance of continuing operations even during very challenging economic times.
The next step is determining how large of a reserve is needed. Clients often ask us how much cash they need to keep in reserve. However, the answer varies from one business to the next. Let me explain.
Are You in a “Nice to Have” or a “Need to Have” Business?
Scenario 1: Non-essential businesses
Some businesses suffer cash flow problems during an economic downturn because their products and services are non-essential. For example, the purchase of golf clubs is easily postponed in the midst of recession. Golf shops, therefore, would be advised to have comparatively large cash reserves to get them through a rough patch. Being fairly conservative in our outlook, we might advise this type of client to build a cash reserve that would cover all business expenses for a period of six to nine months.
A cash reserve of that size affords the business owner a significant amount of financial flexibility. Even in the worst recession, cash receipts don’t come to a screeching halt. Some percentage of customers will have a hard time paying their accounts on time, and sales will suffer a setback. A really bad month might see year-over-year cash receipts decrease by 50 percent. If an owner has nine months’ worth of expenses set aside in cash reserves, he could last through 18 really bad months just using cash reserves. That’s a nice cushion.
Scenario 2: Businesses with choppy, unpredictable cash flows
For example, consulting practices are notorious for having a very good month, in terms of cash receipts, followed by one or more cash-poor months. Whether it’s a good or bad month for cash receipts depends on what projects are in progress, the stage of completion for those projects and when progress payments fall due.
A business like that needs a cash reserve that is large enough to carry it through the predictable condition of low cash receipts, as well as the possibility of economic distress exacerbating the problem. We might advise this type of client to hold nine to twelve months’ expenses in cash reserves.
Scenario 3: Essential businesses
At the other end of the spectrum are businesses that provide products or services that are essential and have rather predictable cash flows. An orthopedics practice is a good example. When a bone is broken, getting it treated promptly is an absolute necessity, no matter what’s going on with the economy. So, revenues of an orthopedics practice could be pretty strong. At the same time, the practice isn’t entirely immune to a struggling economy. Some patients will find it harder to pay their bills on time. A practice like this might need a cash reserve equal to three to six months’ business expenses.
Think Defensively
During a poor economy, a business owner has to manage liquidity by closely monitoring three sources of cash:
- bank accounts
- cash from outstanding accounts receivable
- available lines of credit
Alternately tapping cash reserves and lines of credit further extends the time that the business can operate with a negative cash flow—i.e., business expenses exceed cash receipts.
During a business contraction, banks may withdraw some of their outstanding commitments regarding lines of credit. For this reason, running through all of your cash reserves before tapping credit lines may not be advisable.
What About Factoring?
Finally, customers who are suffering a cash crunch sometimes ask about the possibility of selling part of their accounts receivable—a practice known as factoring. It is a way to accelerate cash receipts without having to dip into cash reserves or lines of credit.
However, factoring can be quite costly depending on your arrangement with the factoring firm and how well your customers pay. The factor may charge you an upfront fee for the amount of receivables sold and include an escrow for a customer account not paid on time. Business owners need to make sure that the fees paid don’t deteriorate their business profits too much.
If your business is suffering cash constraints, or if you foresee the possibility, seek the advice of a financial advisor for a thorough discussion of your options. Let us know how we can help.