6 Factors to Consider when Calculating your Business Cash Flow Reserves

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How Should You Calculate Your Company’s Cash Reserves? Consider These Six Factors

As a business grows and matures and founders take a more critical look at their business finances, they will wonder: how much should there be in the company’s cash reserves? How long should that money be expected to carry a business? What is “runway” and how is it calculated?

Entrepreneurs who search the Internet for answers to these questions might learn that many experts recommend having three to six months of cash reserves on hand. Unfortunately, generic advice may not help every business owner determine ideal company cash reserves. This article contains a basic primer for understanding how to calculate cash reserves based on a business’s unique characteristics – and when to start considering cash reserves as a strategic part of business planning.

What should cash reserves cover?

For many businesses, the first step to calculating the ideal level of cash reserves is to calculate monthly expenses. This figure should include fixed costs, such as rent, utilities, insurance, leases, debt service, or staff. It should also include variable costs, such as how much is spent on marketing initiatives, production, or travel. The total figure should represent how much the business needs to have on hand to keep the lights on and payroll met every month. Each month worth of expenses in the bank is one month of business “runway” that will allow an organization to continue operating even if profits decline.

For example: if a business spends $100,000 per month and has $300,000-$600,000 in the bank, it would be able to sustain operations for 3-6 months without needing to let team members go or dial down current projects.

But exactly how many months of cash reserves or “runway” should a business aim for? Here are several factors to consider for business owners who are beginning to set ideal company cash reserves:

  1. Does the business have seasonal fluctuations? If most of the business’s revenue is generated during the holiday season or over the summer, sustaining operations may require cash reserves that can support the business through six to nine slower months.
  2. Is the business expecting or planning new growth? Although business growth can add revenue, it can also drain cash reserves. Hiring new employees to support growth initiatives may mean removing cash from reserves before new hires have an opportunity to replenish it. The same holds true for new advertising or marketing efforts that may take time to generate profit.
  3. Is any equipment or space in immediate need of an upgrade? Current cash reserves may be enough to support an organization through several months of “business as usual,” but purchasing a new piece of equipment or adding new office space could quickly drain reserves and alter that runway.
  4. How would the business navigate a worst-case scenario? A company’s cash reserves should be enough to support it through an expected slow period as well as through unexpected catastrophes. Before deciding on how long cash reserves would need to sustain your business, business owners should consider what might happen to revenue or cash reserves if a large client canceled their contract. One option is to run a model to see what might happen if the highest-performing sales channels suddenly start underperforming.
  5. What are the business’s strategic plans for the next 12-24 months? One of the most important factors for business owners to consider is the long-term vision and strategy for the business. When business owners begin to consider their cash reserves in the context of where they may be headed over the next one, two, or five years, building cash reserves to support long-term initiatives can become a strategic priority. Instead of thinking about cash flow reserves as a means to support the worst-case scenario or business as usual, many business owners may want to think about their business runway as something that gives them the freedom to think long-term and strategically about the impact their business could make.
  6. Where should business owners begin?  The very first step for many business owners who want to better understand their cash reserves is to begin by calculating expenses. In fact, many business owners who regularly review their bookkeeping will have a loose idea of monthly expenses. A 13-week rolling cash flow report and a statement of cashflows are the minimum financial reports focused on cash that a business owner should be reviewing on a monthly basis. 

When it’s time to start understanding the impact that cash reserves might have on a business’s ability to make decisions, entrepreneurs should consider adding financial projections and long-term strategic planning to their quarterly planning.

When that happens, The Sharp Financial Group is ready to help.

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