Managing cash flow as a small business owner is a lot different than tracking it as an employee. Rather than receiving a paycheck for a certain amount in regular intervals, your cash flow is more sporadic. Maybe you collect invoices at the beginning of the month and are left counting pennies at month’s end. Or fluctuations in seasonal sales lead to several profitable months followed by scarily slow ones.
It’s no wonder 60% of small business owners don’t feel knowledgeable about accounting or finance.
During those slower times, SMB owners can lean on their cash reserve. Below, let’s look at what cash on hand means, how much you need, and how to get it.
What is a cash buffer and why do you need one?
A cash buffer, also called cash on hand or cash reserve, is a sum of money you have set aside with no immediate use or spending plan. It acts as a safety net for when you need a sum of money, often unexpectedly. Small businesses typically put this money aside so they can tap into it when they need it, such as during an emergency or when a business investment opportunity pops up.
Having a cash buffer is extremely important for entrepreneurs and SMBs. According to one study, 30% of businesses fail because they run out of money. Having a cash reserve can help you make sure you stay in business in case of any cash flow problems or unexpected expenses.
There are many specific reasons why it’s important to have a cash buffer. For example, when you’re facing cash flow problems and not turning a profit, this rainy day fund can keep you from going into panic mode or making poor business decisions out of desperation.
But a cash buffer isn’t just for when times are bad. It can also unlock more profitable opportunities. Let’s say you operate a brick-and-mortar store, and the property next door goes up for sale at a bargain price. You can tap into your cash buffer to invest in the property and expand your storefront or rent it out to a tenant.
How much cash buffer do you need to stop any cash flow problems?
According to one JPMorgan Chase study, the average SMB has a cash buffer on hand to keep running for 27 days. Is that enough? Well, it depends.
For most, the answer is probably not. Many experts recommend you have three to six months’ worth of personal expenses saved up for your own emergency fund, while businesses should aim for a year’s worth of expenditures. But this also varies for each business.
To start, it’s a good idea to look back at the past year’s business financials, taking both inflow and outflow into account. Break down your “known” monthly expenses—things like rent, utilities, internet, software subscriptions, etc. Then look at your other predicted, one-time expenses. This includes investments in inventory, marketing and advertising expenditures, and other costs to run your business.
Look at how much you spent in the past year using those inputs. That will give you a rough idea of how much money you need to operate your business for a full fiscal year.
You also need to consider your cash inflow, though it’s best to be conservative when forecasting income. Create a cash flow projection, accounting for both accounts payable and accounts receivable so you can predict just how much money you’ll have. You can use this number to calculate the burn rate, which tells you how quickly and how much you spend above your income.
You’ll also want to dig a bit deeper. Maybe last year was a business-building year, and expenses were higher than usual because of the investments in your biz. Fluctuations happen, and if you have multiple years of data, it’s better to look at them holistically and see the variation in each year’s expenses.
Other factors to consider:
- Do you experience predictable seasonal fluctuations? The amount of cash reserve you need may also fluctuate throughout the year. Consider breaking it down by quarter to see when you need extra on hand.
- What are your business goals? If you’re happy with your current level of success, this straightforward approach may work fine. But if you have big growth goals, you’ll likely need more money for investments.
In the end, the amount of cash buffer you need really comes down to what makes you most comfortable. Some are more conservative in financial matters and play it safe with a bigger buffer. Others might feel comfortable with six months’ worth of finances stashed away.
If you’re still unsure, talk to your accountant about your concerns and collaborate until you land on a comfortable number. Not enough cash could mean the end of your business, and too much could tie up money that could otherwise be invested to improve your business.
Run through potential scenarios—your store is flooded, you face an unexpected health crisis, your rent increases, etc.—though hopefully, you won’t have to deal with these unfortunate circumstances, it’s always best to have a contingency plan.
Cash reserve formula
There are a few formulas you can use to calculate how much cash buffer you need. To give you a solid idea of the amount that would work best for your business, plug your financials into one of these formulas:
Cash Buffer = Cash Balances / Cash Outflows
Cash Buffer = [(Current Assets – Annual Liabilities) / 365] X Number of days you want to cover
Cash Buffer = (Monthly Inflow – Monthly Outflow) X Number of months you want to cover
Essentially, each of the above formulas will work out to the process described in the above section. You have to choose the amount of time you want to have a cash buffer to be able to cover—in other words, how many days can your business survive without any income—before you can determine exactly how much money that equates to.
How to build up cash on hand
If you don’t have a cash buffer already, or you’ve decided that you need to build on your existing one, there are many strategies that can help you meet your goal. First, you should open a bank account dedicated to holding your reserves. The account should be used only for this purpose.
Next, look for ways to reduce your expenses. This is one of the easiest ways to find “hidden cash” in your business. Audit your outflow and analyze your expenses, big and small. You’ll likely find many costs that can be reduced or even eliminated completely.
For example, one great way to cut costs is to go paperless. One study from MultiBriefs showed that businesses spend $80 per employee on paper each year, and another totals global expenditure on paperwork to be $8 billion. And Capgemini Consulting found that paperless companies are to be 50% more profitable.
But there are other more proactive ways to generate money to set aside for your reserve:
- Consider small business loans. A Federal Reserve report states that 40% of U.S. business owners applied for a loan in 2017.
- Explore financing options. Check out SBA financing, a line of credit with your bank, and invoicing factoring (a loan for the value of your outstanding invoices).
- Create a passive income stream and allocate all of that money to your cash reserve fund.
- Adopt the profit-first method. This system is based on putting all of the ideas discussed in this article (and then some!) together to build a sustainable business.
Curb cash flow problems by building a buffer
Determining the ideal amount for your cash buffer requires a balance between data-driven calculations and intuitive gut feelings. It’s a matter of finding out what makes sense on paper, but also what makes you feel comfortable.
Building a cash reserve can make you feel confident in your business, enable you to take more risks, and protect you when times are tough.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.