Accounting & Bookkeeping

How Much Cash Is Required for Your Business’s Safety Net?

How Much Cash Is Required for Your Business's Safety Net
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Liquidity is crucial in every firm. To fulfill your duties, you require enough money. Therefore, over time, the amount of money coming into your company must be more than or equal to the amount left.

Businesses can tolerate short-term negative cash flow by using up reserves, selling assets, or raising money (either debt or equity). The magnitude of the hole you are digging each month, the number of reserves you have, and your ability to raise money all influence how long you can sustain negative cash flow. However, eventually, you must have positive cash flow, or the company will fail.

Run A Cost Analysis

Run A Cost Analysis
Run A Cost Analysis

First, you must be aware of the available operating capital (essentially the liquidity in your business). Then, subtract your liabilities (monthly loan payments, accounts payable, etc.) from your current assets to get this number from your balance sheet (money in the bank, payments owed to the business, and inventory value).

Next, figure out your operating costs for the previous 12 months (look to your income statement for these numbers). These include rent, utilities, and other recurring monthly costs. To determine your daily operational expense, divide this number by 365. (what it costs to run your business each day). The number of days you can fund operations based on your cash is determined by dividing working capital by daily operational expenses.

You should be able to compute your contingency fund budget from now on. Avoid going overboard, but make sure you have enough money to keep your company operating for a few months in case troubles develop. It's a good idea to consider various possibilities, such as the difference between a one-month and a three-month business decline.

Also, remember that your overhead expenses (such as bank loans and lease payments) won't alter over this period, so you'll need a plan to pay for these as well. However, during a slow period, you will make some savings in terms of manufacturing or sales costs.

Have A Safety Net for Your Business

Have A Safety Net for Your Business
Have A Safety Net for Your Business

Beyond paying your bills on time each month, it is a good idea to have a safety net—a cash reserve—to see you through tough times. For example, imagine if a key client refuses to pay your bill or if sales suffer a sharp downturn. These things happen frequently, so having a sizable reserve can help you get through the crisis long enough to make the necessary improvements to your company.

The extent of the safety net you require depends on your company's volatility. A cash reserve that covers a few months' worths of your obligations may be adequate in solid enterprises. However, you could need a safety net to get you through a dry spell of six months or more in more unpredictable industries.

The business won't suffer from liquidity levels above a decent safety net. However, we have observed businesses with plenty of cash overspending.

Holding a lot of cash is a bad choice because it is an ineffective use of capital, even if you don't overspend. It is much wiser to use the money toward expanding your company or give it back to shareholders so they can use it for other investments. It may be wise to create a war chest or a fund that can be used to grow your company organically or through acquisitions if you want to reinvest the funds in your company.

If you give the money back to the shareholders, you can pay a dividend or buy back the company's stock. The most common method of returning capital to shareholders is through dividends. However, if a publicly traded corporation thinks the share price is too low, it may repurchase stock. Repurchasing shares is most frequently done by privately held companies in connection with an ownership change, like a leveraged buyout.

Conclusion

Business’s Safety Net
Business’s Safety Net

All businesses should maintain adequate cash. First, ensure you comprehend how much liquidity your company requires and create a strategy to obtain it. Then, contact Profit Jets and let our finance professionals help you manage your business finances.