How Much of a Cash Reserve Does My Business Need? – Post #7

No matter how strong your business plan is or how well you grow your team, if your business does not have enough in its cash reserve to survive financial storms, selling your business will be a non-issue. In order to secure outside funding or know how much money you need to save personally, you must know how to calculate how much of a cash reserve your business needs in order to open and have on hand to withstand hard times.

Fast Cash and Big Spending – a Thing of the Past

During the years 2004 through 2007, I observed an interesting economic phenomenon. It seemed like everyone and his brother was jumping into the home construction business. I remember people leaving their long-time jobs, going to banks, borrowing half a million dollars, and building massive houses. Many aggressive individuals managed to make some fast cash during that time.

As I watched this market boom, I noticed something else. Sure, these entrepreneurs were making significant cash revenue. They were also dramatically increasing their lifestyle expenditures. They were living high on the hog, if you will. Well, all is well and good until it isn’t. Beginning in 2007, an economic downturn thundered through the nation. Because many of the “quick buck builders” spent their thousands or millions as quickly as they made them, they didn’t have cash reserves to weather the storm. Ultimately, many filed bankruptcy.

Withstand the Economic Storms

A key, if not the key, to business survival, is to start with enough money to get through the tough times. To withstand the storms that will eventually come, we business owners must build a company that has sustainability. In other words, we must have enough cash reserved to reach consistent profitability.

You may already be months or years into your business. In that case, your sustainability depends on your ability to squirrel away enough money during seasons of prosperity to survive the coming barren seasons. Inevitably, every business will face turbulent times. We business owners have to build a business that can withstand the storms.

Without substantial resources to sustain profitability, businesses will most likely fail. But lack of cash can’t be the only reason companies fail. I’ve seen many clients begin a business with more cash capital than others will make in a lifetime. I’ve also seen those same clients go bankrupt and close their business doors.

Reasons Businesses Fail

What, then, causes businesses to fail? After doing my own extensive research, I believe that Chicago business owner Jay Goltz offers the most plausible answers to that question. In 2011, the nytimes.com published his article, The Top 10 Reasons Small Businesses Fail. Let me break down his reasons in my own words:

1. Product cost comes too close to its sale’s price.
2. Owners’ stubbornness, perfectionism, or greed get in the way.
3. Success happens too quickly for companies to keep up with demand.
4. Owners with financial knowledge fail to oversee their accounts/owners without financial know-how try to handle their own accounts.
5. Business does not have enough cash capital.
6. The company fails to rise above mediocre customer service or product offering.
7. Owners pay too much or too little for operational expenses like rent, equipment, and labor.
8. Management fights amongst themselves or with employees.
9. Owners don’t develop an exit plan.
10. A company’s product or service becomes outdated or unnecessary in the current market.

While all ten reasons cause businesses to fail, I believe number 5 is the number one reason businesses go under. From my own observations as a CERTIFIED FINANCIAL PLANNER™, I find that many businesses simply don’t have enough cash reserves to weather storms that come.

How to Calculate Your Business’s Cash Reserve Amount

That leads me to the next issue: determining how much cash reserve will be enough to sustain us through the tough times.

In most circumstances, businesses can predict capital needed with a pro forma financial statement. The methodology within the hypothetical calculation applies to almost all types of businesses, so let’s go through this process together.

• Decide how long it will take your business to move from start-up to profitability. – Let’s say it will take us two years before we become profitable.
• Calculate anticipated recurring monthly, quarterly, and yearly expenses you will incur during that time frame. – Let’s assume we’ll spend $1,000,000 over that two year period.
• Conservatively estimate the gross income you will receive during that time frame. – Hypothetically, we’ll earn $800,000 within that time frame.
• Subtract the projected income from the predicted expenses to calculate the shortfall. – $1,000,00 minus $800,000 equals $200,000.

Our projected $200,000 shortfall is the bare-bones amount of cash reserve your business will need for sustainability, for survival amidst the forthcoming storms.

Don’t stop there, though. Notice that I said “bare-bones amount.” I like to add another 20% or 30% buffer into my projected business cash needs. Therefore, if my calculations tell me I need a $200,000 cash reserve, I might want to begin with $250,000 to safeguard myself against unforeseen circumstances.

How to Fund The Cash Reserve

By this point, you may be saying, “How in the world can I get this much money to start my business?” If you’re already in business, you may be wondering, “Do you honestly think I’m going to be able to save that ungodly amount of money when I’m barely getting by day-to-day right now?”

This can work. You can find funding for cash capital and cash reserve, but the funding available will most likely depend on how realistic your pro forma is. With a strong, projected financial statement, you can:

• Apply for a bank loan or line of credit.
• Get a loan from the Small Business Association.
• Reach out to an outside investor, or loan shark.
• Tap into a rich family member’s pockets.
• Save the money yourself.
• Sell assets you already own.

Stash the Cash

Since you know that cash is king in business sustainability, keep it. Squirrel it away. Put it in a savings account or a CD you can’t get to easily. Protect it. Invest it. Pay yourself first. Give yourself 10%, 15%, or 20% of your business’s gross income each month to create an emergency fund.

Then, do whatever it takes to get more customers. When times are good, pour extra income back into marketing and advertising so more people know you’re around. Furthermore, take care of the customers who come through your door so that when customers have to be stingier with their money during the rough times, they’ll come back to you instead of your competitors.

Cash Out

So if the whole point of this blog series is to build a business to sell it, we have to focus on sustainability. Economic storms will come. Maybe they come during natural disasters like floods, earthquakes, or tornadoes. Perhaps they come when loved ones fall ill or family members begin feuding. No matter how the storms come, we know they’re coming.

Therefore, we stabilize our business’s scalable foundations with strong management systems. Then, we recruit the best team members we can afford to build the framework of our business’s value. But if we stop there, we’ll have no safeguard against the storms. Even if we build our business on the proverbial rock, without additional cash reserves, cushions, or protections around the structure, we’ll likely still be swept away by the waves or receive a pittance in return for our investment.

Guys, I know. Life is hard. Business is stressful. Money doesn’t have to be. Let’s continue to make our lives, at least, financially simple.

Don’t miss our next post in the series dealing with your personal sustainability.