Do you believe your small firm has surplus funds? If that’s the case, pat yourself on the back. According to experts, the average small firm has only 27 days of cash on hand.
You might be tempted to save the extra money in your savings account for a rainy day. As the year 2020 has shown, you never know what the future holds. That wouldn’t be a wrong decision, but it’s riskier than it appears because there’s a considerable likelihood we’ll experience substantial inflation in the following years.
For instance, the Consumer Price Index (CPI) increased 5% from a year ago in May. This data means that whatever money you’ve held over the past year is now worth around 5% less. That may not seem like much of a loss, but if the current pace of inflation continues for a few more years, there will be significant issues with the cash balance.
The question is how you should spend your extra cash. In a moment, we’ll get to that. First, let’s figure out how much money you should retain in your company’s bank account.
How Much Money Do You Require?
We can all agree that 27 days’ worth of cash is insufficient. But how much is sufficient?
According to specific financial advice, small company owners should preserve cash reserves equivalent to 3-6 months of costs. That’s a nice place to start, but everyone’s situation is different so the solution will vary. Three months should be plenty for some. Even six months’ worth of costs would be too dangerous for some.
The following factors will influence your company’s financial situation and money:
Variable Costs
It’s great if you can forecast your spending with fair accuracy. But what if you’re unable to provide short-term spending forecasts? Perhaps you have a loan with a variable interest rate. Perhaps one of your essential raw materials has a lot of price swings. If you’re not sure how much money you’ll need, it’s best to be safe and build up a more significant cash reserve.
Expected Costs
Let’s imagine your monthly company costs have been $40,000 on average for the past year. Isn’t it true that you should have $120,000 to $240,000 in cash on hand in such a case? Perhaps not.
Use $60,000 per month as your starting point if you estimate your spending to be $60,000 per month throughout the following year. With $60,000 in monthly spending, the 3–6-month rule suggests you’ll need $180,000 to $360,000 in cash.
Variable Revenue
While the 3-6-month guideline is based on your costs, your cash demands are greatly influenced by the riskiness of your incoming cash flows (sales). Here are a few questions to ponder.
Do you have a subscription service, or do you only sell one-time items? If you choose the former, your revenue will be more predictable than the latter. Do you own a startup or a young company with a shaky sales forecast? Or a company that has been in operation for decades? How has your firm fared amid economic downturns if you’ve been in business for a long time?
To expand on that final point, you may determine your cash needs by looking at your business’s performance through previous downturns. Let’s assume your company spent four months’ worth of cash reserves during the Great Recession and six months’ worth of cash reserves to get through the pandemic. In that situation, you should have at least six months’ worth of cash in your company bank account.
How to Agree on a More Accurate Cash Amount
Unfortunately, there isn’t a formula to tell you exactly how much money you should save. However, you may arrive at a reasonable figure by considering the above criteria.
For example, if your revenue and costs are both very volatile, you may want to retain six months’ worth of spending in your bank account – or perhaps more. If, on the other hand, your company has been profitable for the past 25 years, three months’ worth of cash may be sufficient.
What if your position isn’t so straightforward? Or if the data has overwhelmed you or your management team? In any scenario, you should seek the advice of a Certified Public Accountant (CPA) to determine how much money you should maintain in your bank account. After you’ve decided how much cash and cash equivalents to maintain on your balance sheet, you’ll need to devise an investing strategy for the remainder.
How to the Money You Have Left Over?
For your company’s capital, there are two types of investment options. One is investing in income-producing assets, and the other is making investments in your firm.
Investing in Income-Producing Assets
In the absence of high-return-on-investment (ROI) company ventures, you might invest your spare capital in other income-producing assets. Your risk tolerance and short- and long-term goals will influence your portfolio selections. MicroStrategy, for example, borrowed $600 million to acquire Bitcoin at one extreme of the range. To undertake something like that, you’d need a lot of faith in future cash flows and a lot of risk appetite, so it’s not a good idea for most small business owners.
However, alternative solutions offer good returns while posing a little risk.
The Stock Exchange
Few investments have outperformed the stock market over lengthy periods. However, more considerable gains come with a higher risk. On several times, the stock market has swiftly lost one-third (or more) of its value, and investors should expect similar volatility in the future.
Bonds
There is something for everyone in the bond market. You may put your money in treasuries if you want to be safe. You can choose foreign government or corporate bonds if you want a greater rate of return and are ready to take on additional risk.
Markets for Money
A money market fund is a type of mutual fund that invests in very short-term debt. The funds are meant to provide investors with a high level of liquidity while also minimizing risk. However, such safety comes at a cost, especially in today’s low-yield climate.
Treasury Securities That Are Inflation-Protected (TIPS)
Treasury inflation-protected securities may be your best choice if you want to protect yourself from inflation without investing in a risky asset. They are inflation-indexed, meaning that their price adjusts to retain their true worth when inflation rises.
Investing in Your Company
For various reasons, Amazon has grown to be a trillion-dollar corporation. Still, one of the most important is that Jeff Bezos has consistently re-invested his earnings back into the firm. While a trillion-dollar value may be out of reach, small business owners may use their extra capital to grow their company.
Here are a few possibilities:
Introduce a New Product
Change is the only constant. Some businesses see more change than others, but a stagnant firm in any area is a sitting duck. With this in mind, you may consider investing part of your surplus cash in the introduction of new items. You may need to recruit additional people, invest in equipment, and execute a marketing campaign to launch a new product effectively.
Invest in Assets
To assist boost sales, your company may require real estate or equipment. You may use your extra income to put a down payment on an item – or buy it outright. Debt should not be taken lightly, but getting a fixed interest rate loan in an inflationary economy may save you money because you’ll be making duplicate monthly payments with progressively worthless dollars.
Purchase a New Company
You don’t have to sit on the sidelines if you think an up-and-coming firm would be an excellent fit for your existing business. You may make an offer to purchase the company. Depending on the size of your company, this might be costly, so you’ll need a lot of cash on hand. However, this is a fantastic strategy to expand your market share.
Make an Appointment with a Financial Advisor
You might wish to see a financial expert and determine the best investment combination for you. By doing so, you can locate the best portfolio for your small business by balancing your immediate and long-term needs with your risk tolerance.
Conclusion
Whoever said “cash is king” was correct; having cash on hand is critical. On the other hand, you don’t want to have too much cash on hand. Not only is there the risk of inflation eroding the value of your money, but there is also the potential cost of lost business development or investment income.
However, devising the correct approach may provide stability and upside possibilities.