Cash is an essential asset for an organization. Since it is one of the most significant liquid assets in an organisation’s balance sheet, it is necessary to maintain a healthy cash balance to cover your day-to-day needs.
Why is it Essential to Have an Adequate Amount of Cash in Hand?
Cash is king! Cash is required to meet financial obligations to staff, consumers, and vendors. Having adequate cash will help avoid taking on debt. Having less or no debt will enable you to have better control over your business and also allow you to work productively without the pressure of debt. It keeps you going when there’s a low demand period and no sales. Also, in a natural catastrophe, adequate cash will enable you to stay afloat and run your business. Your financial statement will provide you with all the information about your business’s health. The cash flow statement will give you insight into where your money is coming from and where your money goes.
Now that you have understood the importance of adequate cash for your business, you might be thinking about how much cash you should have on hand for your business. Having too much cash without the ability to reinvest may have you missing out on opportunities. On the other hand, if you have no cash, you might not be able to operate. Finding a good balance is the key.
What is the Minimum Cash Requirement for a Business?
You must have read or heard a lot about how an individual should have an emergency fund covering about 3 to 6 months of expense. This thumb rule is applicable for businesses as well. The usual guideline is that your business should have 3 to 6 months’ worth of operating costs in cash at any one moment. The idea is that you will have enough funds even if there are a few months when you have no cash inflow.
You will get an idea of your monthly operating costs with the help of your recent income statement. Your operating cost will be the sum of overhead costs and production costs. After you’ve figured out your monthly operational expenses, you can multiply them by the number of months that feel appropriate, usually 3 to 6 months.
For a business with a seasonal sale, you will need to make some modifications to this method. You must consider one high-expense month and two average expense months; you can increase the ratio when considering more than three months’ operating cost.
How Many Months Should One Consider?
Of course, there are many other subjective elements apart from operating costs to consider as well. And this method still has some grey areas as we are not sure how much we should consider, whether it will be three months, six months, or somewhere in between. The number of months will be dependant on –
Business Stage: It is difficult for a business to set apart six months’ worth of operating costs in its starting stage. A growing business can set aside six months’ worth of operating expenses. Consider having a minimum of 3 months’ operating cost in such a case.
Industry: The industry your business also belongs to makes a massive amount of difference. For example, a bank will need more cash in reserve as compared to an e-commerce business.
Type of Business: If you have a seasonal business, you will find setting aside less cash in hand is feasible, but for a regular running business, consider setting aside more cash in hand.
Future Expenses: Take into consideration of your any high-cost expenses that you might need to incur. You set aside a considerable chunk of cash in reserve when you have to buy machinery that is a must for your business operation.
Expected Income: Income is not as simple as expenses. Expenses are easier to predict. However, one must be conservative when making income predictions. Being conservative means keeping in mind that your income might decline and so you must plan your cash reserve accordingly.
It would be best if you regularly analysed your cash flow, considering the importance of adequate cash in hand and the complexity involved in calculating the right amount of cash in hand. A cash flow statement will help you analyse your business’s financial health and understand your cash flow pattern. Further, a cash flow projection or forecast can be a helpful tool to identify your anticipated earnings and expenses. You can easily prepare a cash flow projection for about a year without much trouble. As a business owner, you might find it difficult to prepare a cash flow forecast or statement that will enable you to calculate adequate cash in hand requirements. It is perfectly fine as not every business owner has in-depth accounting knowledge. You can always hire a virtual accountant to find out the ideal cash in hand amount for your business. Nowadays, online bookkeeping service providers are proficient enough to guide you through strategic decisions like cash balance dilemmas. They can also help to streamline your business finance and help you achieve your business goals.
