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Determining Your Cash Reserves

Updated: Apr 19, 2020

In the words of Steven Rogers, “For any business positive cash flow is king.” Cash is needed for buying inventory, purchasing equipment, paying bills, completing payroll, paying utilities, and repaying debt.

Why is it Important?

It’s essential to take into account the externalities that affect the cash flow of a business. For example, the inherent business risk a company faces will strongly influence its cash flow variance. A consumer discretionary business like Harley Davidson will experience greater cash flow reduction during economic downswings than a consumer staples business like Procter and Gamble.

Predicting and preparing for these cash flow downswings will prevent a cash shortage through high cash flow variance periods. Many small business owners focus closely on income statements and balance sheets but forget to analyze their cash flow. I’ve seen and heard countless stories about established businesses being caught off guard in cash shortages. This commonly led to their top-level executives contributing their own cash just to complete their accounts payable for the month.

Learn From Past Mistakes

Let’s backtrack to March 2000, when the dot-com bubble began to burst. By this time, most dot-com companies (a company that does most of its business on the internet) spent massive amounts on advertising and promotion for years to secure market share.

However, this spending racked up an unproportioned amount of debt compared to their cash inflow and cash reserves. Many companies incurred net operating losses, but their debt tolerance remained inelastic to their increasing debt levels. The commonly used motto “get large or get lost” pushed these businesses to incur more debt in hopes of gaining market share.

When the dot-com bubble burst, valuations tanked for these businesses, and they were left facing massive accumulations of debt. Most companies didn’t survive through this market trough; their collective debt and undersized cash reserves led to their insolvency.

Many of these bankruptcies could have been prevented, had these businesses taken into account their business risk (relatively high in the information technology sector) and financial risk (very high from levering up on high levels of debt). If this were the case, many more businesses would have made it through this market trough into the accumulation stage of this market cycle (began late in 2002).

How You Can Determine Your Optimal Cash Reserves

A good rule of thumb for determining your cash reserve is to aim for 3 – 6 months of expenses. The dot-com market recession lasted for over 2 years, so obviously this cash reserve target is not always a guarantee of survivability through all market troughs. However, allowing both business and financial risk to influence cash reserve targets will increase the accuracy in determining the optimal cash reserve target.

Business risk is the inherent risk a firm experiences depending on the industry(s) they operate in. For example, the information technology sector is hyper-sensitive to changes in the economy, whereas the consumer staples sector is relatively inelastic. A company like Walmart is exposed to lower levels of business risk than a technology company like Apple. The higher the business risk is, the more cash is needed in reserve to mitigate the variance in cash flow.

Financial risk stems from the total amount of debt a business has on its books. With higher debt payments comes a higher cash demand. More cash is needed during the payback periods to meet these debt obligations. Otherwise, if debt payments are not met, the company will default on its debt and become insolvent. The more debt a business has, the more cash is needed in reserve to weather cash flow variance.

A business’s cash reserve should be scaled based off of these two factors, as well as any other externalities that may affect cash flow, such as the cash conversion cycle (I will cover this topic on a separate blog).

How deep do you keep your business's cash reserves? Drop a comment below with your thoughts!

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