Today I answer the question I've gotten probably more than any other question.

We know we need cash reserves... but how much should I keep on hand?

Today we break down:

1. How to identify your cash burn
2. A formula to help estimate cash need

But first, our sponsor.

 

 

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How much cash should I keep On hand?

I came across a survey the other day that said that 34% of SMBs have less than one month of cash on hand.

I can’t say I was surprised, but I was still shocked.

For me, it’s unimaginable to not keep enough cash on hand.

But, I’m also the CFO. And I can look back at businesses I’ve seen and see ones that definitely didn’t have enough cash.

So what gives?

The reality is running and growing a business is hard.

Revenue has slowed and you had a big expense. Seasonal fluctuations mean you’re now pinching pennies till the right season comes back around. You bought too much inventory and are waiting for it to sell through. You’re growing, which means the expenses keep coming as you wait for customers to pay. Taxes snuck up on you and you owed more than expected. Or, maybe you just mismanaged it.

There are a million reasons businesses don’t have enough cash. The root of all of them? Too many don’t actually understand:

1. The ins and outs of their cash flow
2. How much cash they should actually keep on hand

We’ve talked about cash flow (and will continue to talk about it), but I’ve consistently avoided the “how much cash” question.

Partially because it’s hard, but also because the right answer is it depends.

We can’t truly answer this question without looking at your specific business and personal situation.

So, I did what all good content creators do: I googled it.

And when I google it, the results are subpar…

“Keep 3-6 months of expenses” is the rallying cry from almost everyone. But what does that actually mean?

So, to make this more approachable, I’m going to break this into 2 parts:

1. Identifying Monthly Burn
2. The Cash Reserve Formula

A caveat before we dive in: this is for profitable businesses. If you’re not profitable, you are likely skirting by or have funding. With funding, the assumption is you have big inflows and work those down. That’s a whole different approach which we’re not going to tackle in this newsletter.

Identifying Monthly Burn

The first question I get when I hear 3-6 months expenses is “well what expenses do I count?”

So, let’s break these into categories.

When we look at a monthly burn, we want to understand:

1. What is the biggest cash-negative period we’ve had in the last 3 years?
2. What are our “baseline” expenses?
3. What are our debt payments?
4. What is payroll?

“Baseline” expenses are the things you need to “keep the lights on.” For many this is just:

1. Rent
2. Utilities
3. Software/subscriptions required to operate

Once we’ve determined these 4 numbers, you get to create your own formula. What matters to you? What feels “right” for you to include?

Do you want to only keep the payroll amount? Do you want to keep payroll + baseline? Do you want to ensure you never default on debt?

I typically encourage looking at three numbers:

1. Payroll only
2. Baseline + debt + payroll
3. Dollar amount of the highest negative cash flow period

This provides us with a range of monthly cash needed.

Was it a struggle for you to find that number? That means your accounting or tracking system probably stinks. I have a solution for you: ​NetSuite​. They’ll help you track your expenses and provide reporting that tracking your cash burn will never be a problem again.

The Cash Reserve Formula

Next, we determine how many months of this number we want to keep.

To do this, we want to consider the following variables:

• Stage of business
• Your business goal
• Capital needs
• Industry stability
• Seasonal fluctuations
• Customer concentrations
• Supplier-related exposure

Start at the left and move to the right, adding or subtracting based on which of each element most identifies with your business.

 

This isn’t meant to be “gospel,” so adjust it as you see fit. If between two, go up or down the scale based on your comfort.

Ultimately at the end, you’ll have a number of months.

The Result

Now, multiply your 3 burn numbers by the number of months you got from the formula.

This gives you a range of cash you should keep on hand.

Using this formula, we’ve established a starting point.

You could have other cash needs or plans that aren’t incorporated into this model. You could know that you’re going to have big inventory or equipment purchases soon that require you to keep more. Your debt profile also impacts this. What monies do you have available for a line of credit?

This is where the process turns from science to art. Every person will have a different take and that’s okay.

When planning for a cash reserve, you’re planning for 3 things:

1. Peace of mind
2. Sudden, normal, dips in business (seasonality)
3. Sudden, catastrophic, dips in business (like COVID)

For 2 & 3, there are specific purposes. We want to keep enough cash on hand so we don’t have to:

1. “make cuts” during normal seasonality
2. have time to make measured decisions during catastrophic events

As long as you have enough cash for your liking in these situations PLUS the peace of mind that allows you to sleep at night, we’ve achieved our goals.