Learn three simple methods on how to determine how much is enough money to keep in the bank.
- In personal finance, there's a rule of thumb that says you should have three to six months of living expenses in the bank as a contingency fund. But does that rule stand for small businesses too? Well, the short answer's no. Running a business can be more complicated than running a household, with irregular income patterns, unexpected expenses, and the need to invest for future growth. In every business, liquidity is important. And to be liquid, you need to have enough cash on hand to ride out these bumps. You should also have positive cash flow, where the amount of money going into your business is greater than the money going out.
To ensure that you don't need to sell assets or borrow money in case of a cash crunch, it's important to have a reserve of money set aside to smooth the bumps. To determine how much cash you should keep as a reserve, follow these steps. First, know how much cash you're spending at the current stage of your business. A business that is in startup mode spends more on setting up and scaling than a business in maintenance mode. This monthly burn rate, the monthly amount you're spending on staff, rent, equipment, supplies, and marketing is something that you need to be very aware of.
Next, forecast where your future cash is going to come from and when it's going to come in. If you have a long sales and payment cycles, it's especially important to have a clear view on when cash will land in your account. It's important to be conservative, both with spending and with forecast income. It's better to underspend and be overpaid than vice versa. This can be done through software like QuickBooks or an Excel spreadsheet, or even a trusty pen and paper. The important thing is that you look into the future to gauge what your likely expenses and income will be.
So now to figure out how much for cash reserve you need. If your income and expenses are regular and predictable, say, you run a gym with a loyal base of members, you can afford to keep a smaller amount of money in the bank, say, three months of expenses. If you're in a business with longer sales and payment cycles, like professional services or software, make sure you have at least six months or more. But most businesses are complicated, so take a snapshot of expenses over six to 12 months. Look at the average cash flow over that time as your base and then compare that to your highest expense month.
If your highest expense month is significantly higher than the average, add more to your reserve. And, remember, if you have an opportunity to get extra cash into your business, whether it's through an investment or a line of credit, take advantage of it before the need arises. Most businesses that fail do so for the simple reason that they don't have the income to pay their expenses. But can having too much money in the bank also be a problem? We only have to look to Silicon Valley to answer that question. Sometimes even the best funded startups crash and burn.
Why? Well, when you have a lot of money on hand, the human response is to spend it. More people, bigger offices, more money in marketing. When you're not counting every dollar and its contribution to future growth, it's easy to fall into the trap that growth equals success. So what happens six months down the road when the monthly burn is sky high and the income isn't coming in? That's right, they run out of money. So, yes, keeping too high a reserve can be a problem, making you overspend. But a high reserve can also stifle your business. Managers can hold back a company's ability to grow by protecting its cash reserve too tightly.
So, in many ways, having a high reserve can be a problem. In the end, income solves most cash problems. When the money rolls in, problems tend to solve themselves. Keeping a clear view on what it really takes to bring income in is the best strategy of all. But making sure you have enough cash to ride out the bumps is super important too.
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