5 factors determining optimal small business cash reserves

How much cash reserve should a small business have?

For companies with strong cash positions, their question is, “How much cash should a company keep on hand?” Every small business owner dreams of having a large enough bank account that they will need to address this question.

To improve cash flow and profits, first consider five key factors determining the optimal cash level for a small, private company:

• Liquidity needs
• Required reserves
• Expansion opportunities
• Loan covenants
• Availability of credit

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Liquidity Needs

Liquidity is the ability to convert an asset to cash quickly and the ability to meet obligations when they come due over the next year. It was liquidity that killed Lehman Brothers, not lack of equity.

Understanding liquidity is the starting place for determining how much cash to keep on hand. Liquidity involves the cash cycle and other resources or reserves to meet cash requirements.

The cash cycle is the business cycle of working capital. Understanding the cash cycle helps to anticipate the length of time it takes for working capital to become cash. For a company with inventory that sells on account, the cash cycle will start with the need to pay for inventory, which depends on the vendor’s accounts payable policy. Next is the time it takes for the inventory to be sold to create accounts receivable. The accounts receivable collection period is the final step in the cash cycle. An example could be inventory has a immediate supplier payment (COD), inventory takes 30 days to be sold (stocking and selling on average), accounts receivable invoices go out immediately and take 30 days to collect, collections are deposited immediately and funds are available on deposit. Result is a 60 day cash cycle.

It should be clear that at each point, the cash cycle could be longer. The question is whether it can be shorter. Speeding each collection step will reduce both the time and the required working capital. Seasonality analysis shows the needed working capital and primary cash reserves to cover working capital growth during the year. Current market conditions should be factored into this analysis by doing a best case, normal case, and worse case scenarios.

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Required Reserves 

Once the liquidity needs have been determined, then the level of reserves is evaluated. Reserves can be described as the comfort that is needed if things go wrong. How many months of cash reserves should you have? There are rules of thumb, such as:

• 3 months of expenses = rainy day
• 4 – 6 Months of expenses = sleep like a baby
• 6+ months = gambling fund

The key is that in a downturn scenario (or worst case forecast), the company should have adequate liquid reserves to enable the business to continue operations for a minimum of 12 months, after factoring reasonable actions to minimize expenses. Note that accounts receivable may not be considered liquid in this scenario as collections may be difficult to obtain in a downturn situation.

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Expansion Opportunities

Expansion opportunities can arise at any time. In more troubled periods, acquisitions will arise with greater frequency because of both operational and financial stress. These can be very valuable opportunities with attractive pricing.

Having cash reserves for opportunities that come is strategically useful. How much cash would be required depends upon the opportunity.

Generally, one can look at the types of opportunities that a company can pursue and ball park the needed cash. For example, a company with $5 million in revenue will generally consider acquiring a company with under $1 million revenue. The price tag will generally be less than one times revenue with some amount down and a pay-out over time. Therefore, the cash is the down payment plus transition cash requirements.

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Loan Covenants

Existing loan covenants may contain restrictions on cash distributions or levels of equity. Covenants should be evaluated to see if they allow for excess cash.

Total cash requirement

At this point we have a level of cash needed to operate the business for the near future, including reserves and opportunities. Cash balances in excess of this amount can properly be treated as excess cash.

Factoring in Available Credit

Beyond excess cash, the available credit, such as credit lines, must be considered. (A full treatment of the role of credit lines is beyond the scope of this article.) Relative to this topic, a company needs to adopt a view of whether it will be an “all cash” or a “cash plus line of credit” operated company.

We would like to note that business school professors will talk about cost of capital and limiting the shareholder’s investment in a company in order to maximize the return on investment. What the Giersch Group sees in our private companies and what we recommend is a higher focus on maintaining cash and paying off debt. Private companies have severe limits on credit. Private companies need to be able to survive on their own at all times.

A company may adopt the strategy of using a line of credit to backstop available cash. In such a case the line is treated as available liquidity, adding the unused balance to cash for comparison to the needs determined above. However, it is important to recall that in 2009 and 2010 tightening credit markets caused banks to cancel lines of credit, even for those companies that had always been current. A line of credit should also be applied for before the need for one exists. Banks will not loan to a company when it is in need of additional credit and the approval process for a credit line will take four to six months.

The optimal cash level summary

1. Assume all funding will come from cash reserves.
2. Know the cash cycle and seasonal requirements.
3. Basic cash requirements to meet normal cash cycle.
4. Project the working capital requirements for seasonality to see maximum cash needs.
5. Estimate 3 months cash to cover expenses in worst case.
6. Estimate potential expansion options.
7. Review loan covenants for covenant coverage.
8. The sum of 1 to 3 is the targeted cash reserves, with #4 being an outside commitment.
9. Return extra to shareholders.

What to do with excess cash?

Excess cash is a blessing. Keeping it in a private company is not recommended because the purpose of a limited liability company, both corporation or LLC, is to prevent creditors from reaching assets that are not part of the business. Only the amount of cash needed to operate the business should be kept in the business and available to creditor claims. Clearly, there are tax implications to taking money out of the company, but those are beyond the scope of this article.

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