How much cash does your business need?

You know you should keep some cash on hand in your agency to cover expenditures, but how much should you save?

Would you love to have a simple, straightforward answer to that question?

Exactly how much cash your business needs to keep depends on a few different factors, including the quality of financial data at hand, your expectations about the near future, and your risk attitude.

But we can use that information to estimate how much you should hold onto in reserve.

So here are three approaches to determine the size of your agency’s cash reserve in increasing order of complexity.

First, the Rule of Thumb approach suggests keeping a cash reserve equal to three to six months of your business expenses. This amount can provide a good starting point and gives you a cushion in case of unexpected costs or a slowdown in business.

This method uses rough, back-of-the-napkin math to estimate how much cash your business will need over the next few months based on how much it has spent over the past few months. This amount will cover fixed expenses if revenue completely dried up. It’s obviously a nightmare scenario, but we should hope for the best while planning for the worst.

Next, the Financial Forecast approach uses a financial projection to determine how much of a cash reserve you will need. This involves extrapolating your expected income and expenses over the next 6, 12, or 18 months.

Going a step further than the Rule of Thumb approach, forecasts replace back-of-the-napkin math with more robust analysis. Rather than rely strictly on averaging expenses over the past few months, a forecast builds in assumptions about growth trends in both revenue and costs.

With forecasts, you can create scenarios around sets of assumptions, such as a 3 percent increase in revenue month-over-month, a 2 percent increase in fixed (indirect) expenses, and a 5 percent increase in direct expenses (cost of goods sold). Then, you can decide which forecast seems most realistic or probable, and make decisions accordingly.

Finally, the Risk Management approach attempts to plan for major changes affecting business operations and cash flow needs. The starting point is a risk assessment for your business, which identifies the probabilities and likely costs of a host of potential changes, such as hiring a new employee, the onset of an economic downturn, or the loss of a significant customer.

A risk mitigation plan summarizes the assessment and, among other things, recommends a cash reserve amount to cover the estimated cost of likely changes occurring.

This can become a complex undertaking. Large organizations could spend months and millions of dollars on consultants to produce a risk mitigation plan.

But your agency can do something similar at a much smaller—and cheaper—scale. Start by listing a handful of nightmare scenarios that might keep you up at night.

I really like using Jason Cohen’s article on extreme questions for this. Some of these questions get at the heart of risk mitigation in a small business, such as losing all customers, being completely copied by a larger competitor, and the “mortal wound” scenario.

Based on your risk analysis and your risk attitude, you can determine how you would respond, the amount of cash reserves needed to respond, and how probable you think each scenario really is.

So let me know…

Have you used any of these methods to determine your company’s cash reserve?

Would you love to have a more systematic approach to determining your cash reserve?

Hit REPLY and tell me about it!