How Much Cash Should a Small Business Have?

Cash is the lifeblood for any business and one can determine the company’s health just by looking at the cash flows.

An entrepreneur needs cash to pay out salaries of employees and his own, spend in marketing to acquire and retain new customers, invest in equipment and facilities, and pay out rent, buy supplies and to carry out many days to day activities.

Now the major question entrepreneurs have in mind is that how much cash they should have in reserve and how much is enough. Many financial experts recommend three to six months of operating expenses but this theory can’t be applied in many cases.

To determine how much cash you might need, please have a look at the following key areas:

How much cash have you been using?

Keep track of the cash received from sales and the cash spent. The net of these two is often referred to as the “net burn rate.” For example- if you have received Rs. 30,000 after sales and have Rs. 20,000 in expenses, your net burn rate is Rs. 10,000.

Your “gross burn rate” only takes cash expenditures into account. In our example, that’s Rs. 10,000 and is the more conservative amount, since it does not assume any sales are made. Spending patterns of the past are a good starting point in considering future spending plans.

How much cash are you planning to use?

Have a look at the monthly cash flow projection covering the next 12 to 15 months. For start-ups, you’ll find all the details in the financial section of your business plan. Just like the actual cash expenditures, look at the sales (cash in) and expenditures (cash out) separately.

Have a conservative pattern to make a forecast as actual results often differ from what’s mentioned in your business plan. Also, expenses are usually more predictable than revenues because many are relatively fixed in nature such as payroll and rent. And for start-ups, separate the one-time upfront costs needed before you can open your doors from your ongoing operating expenses.

For a small business, one needs to consider the stage of your business in your forecasts.

What stage is your business in?

Are you in an early start-up phase, the first year of operation, maintaining a steady business, or do you have plans to scale your business with a huge impact? Each of these will have different impacts on the cash forecast discussed above. While an established business may have good benchmarks, a start-up has few benchmarks thus should be more conservative when setting cash flow needs.

In growing businesses, accounts receivables and inventory, expand to support the increased sales.

How long will it take to get more cash?

As you have determined your cash requirement for the next 12-15 months, the next consideration is how long it will take to get more cash in times of need. Now, to get the funds likely means writing a check from a bank account or selling a security from an investment account — definitely more than 3 days until the cash is available to use.

However, if you need a bank loan to get cash which most of the startups rely on, it might take at least a couple of months which includes one month to find a bank willing to make the loan and one more month to do the paperwork.

If you choose to raise funds from angel investors, it extends the time even more. If you go this route, be prepared for 6-9 months for preparing the business plan/investor pitch, make presentations to several angel groups to find one that is interested and a good fit, and wait while the angel group finally shows a green flag.

Once you determine the cash amount you’ve been using, how much are you planning to use, and how long it will take to get it, you can determine how much cash you need to keep in the business. For example, if you plan to use a bank loan to fund your cash needs and you plan to spend Rs.500000 a month then you should probably keep Rs.1000000 in your bank account — if there is certain sales revenue occurring in these two months, you can choose to reduce the needed cash in the bank.

Are there other cash sources?

There are many alternative options of cash. For purchases, ask the vendor for credit terms or a longer time period for the pay-back. For sales, ask customers to pay you in short timeframe and offer incentives when they pay early. Other cash sources may include increasing your credit card balances, borrowing from family and friends, tapping into savings and retirement accounts, taking out a home equity loan, leasing rather and purchasing equipment etc.

When is the best time to look for more cash?

This might come as a shocker to you but the best time to obtain funds is when you don’t need them. It’s because during these times you aren’t desperate to take the last minute options available. There is plenty of time to look for the best source, terms, and conditions and you can negotiate to get a great deal.

Too little or too much Cash

The two key items topping the list of most business failures are undercapitalization (when there isn’t enough cash) and overcapitalization (when there’s too much cash).

Not having enough cash is the most common problem faced by start-ups. In another scenario, companies can also get into trouble when they have more cash than needed, as they often undertake projects, hire new employees, buy equipment, move to larger offices, and partake in other such expensive actions, which incur ongoing implications like fixed costs.

Key takeaway:

  1. Determine the amount of cash you’ve spent and had plans to spend in the future.
  2. Determine where you will get the cash from in case of need and the duration to get it.
  3. Now determine the cash amount which you need to retain on the basis of the above points.
  4. Understand the stage of your business to determine if modifications to historical spending patterns are needed when considering forecasts.
  5. Be conservative in your estimates, rarely do actual results match forecasts.
  6. Seek cash when you are in a position to explore options and negotiate from strength.

Next Steps

  1. Update your business plan, budget, and financial forecasts so they give you good information now and are available if and when they are needed.
  2. Research funding sources for future use.
  3. Go to your bank and explore getting a line of credit so you have a safety net if and when it is needed.

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