(This post originally appeared on Philly.com)
Ask any small-business owner and you’ll be told that having plenty of cash in the bank is probably the most important indicator of our financial health. But managing cash flow continues to be one of the biggest issues we face.
Almost two-thirds of small-business owners are “regularly stressed or have anxiety due to cash-flow concerns,” according to a recent survey of more than 500 entrepreneurs from small-business lender Kabbage. More than a quarter of them said that they have gone as long as six months without receiving a paycheck.
Six months without a paycheck seems pretty bad to me. But does it have to be that way?
Most businesses today are benefiting from a strong economy. Small-business sentiment, according to a monthly indicator from the National Federation of Independent Businesses, is at historically high levels. But we all know that things can turn south quickly, and even the most profitable business can still run short of cash if its owners aren’t paying attention.
That is why it’s important for a small business to target a minimum cash reserve to keep on hand and manage its expenditures around that. Doing so would go a long way toward helping us decide whether or not we are able to afford to hire that next employee, make that capital investment, or commit to a large inventory purchase.
So what’s the magic number? How much cash should a small business minimally have in reserve?
“Many believe that a business should maintain cash reserves to cover operations over a three- to six-month period as a general rule of thumb,” Scott Isdaner, the managing member of accounting firm Isdaner & Company LLC in Bala Cynwyd, told me. However, Isdaner cautions that “every small business is unique and has its own cash-flow needs based on its operational model and business cycle.”
Maybe you’re a manufacturer that buys materials at specific times during the year, a retailer that makes most of your money during the holidays, or you run a restaurant down the Shore, and your busiest times are during the summer. Or you’re simply a personal trainer who collects fees up front or a service firm that pays its people as much as 60 days before you get paid by your clients.
Financial planner Stephen Cohn of Sage Financial Group in West Conshohocken agreed. “It’s hard to come up with an amount without first considering whether the business is a start-up or stabilized business, is subject to certain industry needs, has adequate financing available or is subject to large capital expenditures and seasonality or unknown sales patterns, ” he said.
The right reserve, be it three, six or more months of cash, depends on how much you spend now and what you plan on spending in the future. To know that, both Isdaner and Cohn say, it’s important not only to get a handle on your monthly expenses but also to prepare a forecast or budget. The good news is that doing this isn’t as difficult as you might think.
Start by reviewing your revenues and expenses, by month, over the last 12 months. Then add in your cash balance today and look to the future. Using what you know from the past, forecast these monthly amounts over the next 12 months, with each month showing your available cash at the end.
No one has a crystal ball. But, barring anything extraordinary, you should be able to make reasonable estimates of the future based on the past. Make sure to include significant cash expenditures such as estimated taxes, loan repayments, planned capital expenditures, or other unusual, seasonal or onetime items. Be realistic but also conservative. Isdaner goes as far as to suggest doing this analysis using different scenarios (best case, worst case) because he says “it will allow a company to prepare itself for any unknown contingencies it may encounter.”
This isn’t just a rainy-day fund. It’s a critical benchmark for running your business. Having too much cash may mean you’re not making the best use of your capital and available lines of credit or it may be providing you with a false sense of comfort.
Having too little can restrict growth, create stress, and ultimately cause you — like so many other business owners — to potentially go without a paycheck. There’s no reason why we should be making these decisions in the dark.