How Much Cash Do You Need for Your Business's Safety Net?

How Much Cash Do You Need for Your Business's Safety Net?
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In any business, liquidity is important. You need enough cash to pay your obligations. That is, over time the amount of cash that flows into your business must be greater than or equal to the amount of cash that flows out of your business.

You can endure negative cash flow in the short term by dipping into reserves, selling assets or raising capital (either debt or equity). How long you can sustain negative cash flow is a function of the size of the hole you are digging each month, the amount of reserves you have and your ability to raise cash. Nevertheless, you will eventually have to achieve positive cash flow or the business will go bankrupt.

Related: Why You Should Keep Your Personal and Professional Finances Separate

Beyond simply meeting monthly obligations, it is a good idea to have a safety net -- a cash reserve that you keep to help you through lean times. Suppose a big customer doesn’t pay your invoice or sales decline significantly. Such events are common and a sufficient reserve will help you weather the storm long enough to make appropriate adjustments to your business.

The size of the safety net you need is a function of the volatility of your business. In stable businesses, a cash reserve equal to a couple of months of your obligations may be sufficient. In businesses that are more volatile, you may need a safety net that will see you through a drought of six months or more.

In general, liquidity that exceeds a reasonable safety net won’t hurt the business. However, we have seen companies that are flush with cash overspend.

Reece Sewing Machine Company had been in the business of leasing machines that made buttonholes since the turn of the 20th century. It had never sold a machine, only leased them. As a result, the company had a very healthy monthly cash inflow from the lease base with relatively little associated expense. Shortly after World War II, it switched to selling buttonhole machines. Quickly, the company was awash in cash. It was getting all of the cash from the lease base plus all of the revenue from the sale of the new machines it built.

Related: 6 Ways to Make Financial Forecasts More Realistic

This enabled the company to expand its overhead significantly -- which it did. Unfortunately, as machines got old, they dropped out of the lease base, which was no longer being added to. Revenue from that source began to dwindle. Because of the large overhead, cash flow got tight. Then management hit on an idea. They could sell the lease base to generate more cash and allow it to continue to support the vast infrastructure it had built. The result was predictable. In a few short years, the company spiraled toward bankruptcy. The morale of the story is, in spite of abundant liquidity, companies should be frugal with spending.

Even if you don’t overspend, holding significant amounts of cash is a bad idea because it is an inefficient use of capital. It is much more prudent to invest the cash in growing your business or return it to shareholders so that they can invest it in other ventures. If you plan to reinvest the money in your business, it may be prudent to build a war chest -- a fund that can be used to expand your business through organic growth or acquisition.

If you decide to return the money to shareholders, you can do this either by declaring a dividend or repurchasing the company’s stock. Dividends are the most frequent way to return capital to shareholders. However, a publicly held company may repurchase stock if it believes that the share price is too low. Privately held businesses most often repurchase stock as a part of an ownership change such as a leveraged buyout.

Appropriate liquidity is important for all businesses. Make sure you understand how much liquidity your business needs and develop a plan to achieve it.

Related: Don't Make These 2 Mistakes With Your Cash On Hand