Today’s marketplace can feel uncertain, so it’s no surprise that many businesses are stashing operating cash in their bank accounts. However, without imminent plans to deploy these reserves, do these excessive “rainy day funds” really offer efficient use of capital?
If you want to estimate reasonable cash reserves while maximizing your company’s return on long-term financial positions, try this approach.
Why is it harmful to reserve extra cash?
While maintaining a “cushion” can help with slowed business or unexpected maintenance needs, it’s important to acknowledge that cash has a carrying cost. The return your company earns on cash vs. the price you pay to obtain cash may be more significant than you realize.
Carrying debts on your balance sheet for equipment loans, credit lines, and mortgages comes with interest that might be higher than the interest earned on your business checking account. After all, interest earnings on checking accounts are often little to none. Many generate returns of 2% or less.
The greater this spread, the higher the cost of carrying cash.
What’s the ideal amount for a cash reserve?
While dividing current assets by current liabilities is helpful, there’s no magic ratio that’s appropriate for every business. A lender’s liquidity covenants can only provide an educated guess.
Still, it’s possible to analyze how your business’s liquidity metrics have evolved in previous months or years and compare those numbers to industry benchmarks. If you notice ratios well above industry norms—or substantial increases in liquidity—this could be a sign that capital is being inefficiently deployed.
Looking forward may also prove helpful. Developing prospective financial reports for the next 12 to 18 months may help you evaluate whether your company’s cash reserves are too high.
For instance, you might use a monthly forecasted balance sheet to estimate expected seasonal ebbs and flows in the cash cycle. Projecting a truer picture of a worst-case scenario, using “what-if” assumptions, could also be helpful. When examining these scenarios, be sure to consider future cash flows, including debt maturities, working capital requirements, and capital expenditures.
Formal financial projections and forecasts provide a much better method for building up healthy cash reserves than relying on gut instinct alone. Over time, comparing actual performance to this data—and adjusting them, if necessary—will help you reach your ideal reserve.
What to do with excess cash
Once you’ve determined your company’s ideal cash balance, it’s time to find a way to reinvest any cash surplus.
Some possible options include:
- Paying down debt to reduce the carrying cost of cash reserves
- Investing in marketable securities like diversified stock-and-bond portfolios or mutual funds
- Repurchasing stock, especially if minority shareholders routinely challenge management decisions
- Acquiring a struggling competitor or its assets
When implemented with due diligence, these strategies are the key to growing your business in the long run—not just your checking account balance.
Questions? Smolin can help
Need help creating formal financial forecasts and projections to devise sound cash management strategies? We’re here to help. Contact your Smolin accountant for personalized advice on the efficient use of your business capital and the ideal cash reserve needed to meet your business’s operating needs.