There’s no way around it: Cash is the fuel that keeps any business running. Without it, you won’t be able to pay for supplies, rent, or labor. In times of crisis, cash reserves can even mean the difference between pulling through and shutting down.
But how much cash does a small or medium-sized business (SMB) like yours actually needs at any given time? Well, there’s no one size fits all answer. It varies by business stage, industry, and the volume of your revenue and expenses.
In this article, we’ll help you figure out how much cash you need and offer some easy ways to increase your reserves.
Why cash reserves are so important for small businesses
For a business, especially a smaller one, having cash reserves is like having insurance without buying a policy. It means that even when times are rough—for example, due to illness, economic crisis, a global pandemic, or supply chain issues—you’ll have enough to cover your costs until you get back on your feet.
While a loan can also help with a temporary cash crunch, it can take months to be approved for one, and that could be too late. In fact, the average small business only has enough cash to survive for about a month without income, which isn’t ideal.
Having some extra cash lying around is not just for emergencies. It’s also good for when an unexpected opportunity comes knocking. The last thing you want to do is say no to big projects or expansion options just because you’re low on cash at the moment.
Wait, are we talking about cash flow?
Not exactly, but the two terms are closely linked. Cash flow refers to the movement of cash in and out of your business. If you’re bringing in more than you’re spending over a set period of time that means your cash flow is positive, or healthy. Which is great.
But, just keeping your cash flow positive isn’t always enough. What we’re talking about here is making sure you have sufficient reserves or buffers. In other words, money put aside, that you are not using for your day-to-day operation, and can be utilized for unexpected events. This can be a crisis or an opportunity that requires some investment.
Types of cash you can have on hand
Cash on hand doesn’t have to come in the form of actual paper bills. It can also be in a checking or savings account or in the form of tangible assets that can be liquidated quickly. The only rule is that it can’t be money that is otherwise tied down. For example, the minimal sum that needs to be in your bank account to keep it active cannot be counted towards your cash reserves because you can’t access it.
To summarize, cash on hand can include any money or equivalent that can be withdrawn or liquidated easily on short notice, including:
- Physical cash
- Checking accounts
- Savings accounts
- Tangible assets
Let’s talk numbers
There is no magic answer to how much cash you actually need to put aside for your business. The exact sum will depend on your industry, stage, and how much money you can realistically save.
The common wisdom is to set aside the equivalent of three to six months of operating costs. To figure out how much that is, refer to your balance sheets, expense reports, and other financial statements from the past year and calculate the average amount you spend in a month.
How to calculate your operating costs
Check your statements to see how much money you spent over the past year on recurring expenses like rent, salaries, utilities, and taxes, to name a few. Also check how much you spent on varying costs such as equipment, repairs, gas, marketing, raw materials, unexpected expenses, etc.
To calculate your operating costs, add up all of the expenses your business had in the previous year and divide the sum by 12. This will give you the monthly average cost of operations.
Be conservative in your calculations: It’s better to have a slightly larger buffer than to be lacking when the need arises.
How to increase your cash reserves
Now that you know how much cash you need, there are several things you can do to stuff your cash cushion.
Encourage faster payments
We know what you’re thinking: You’re lucky if your customers pay you on time, so how can you ask them to pay even sooner? Well, you won’t really need to ask if you provide them with the right incentives.
You can offer early bird discounts to loyal customers willing to pay sooner for large orders. A 5% discount can go a long way to accommodate your customer and save them cash while giving you an always welcomed infusion.
Another way to encourage earlier payments is simply to make it easier for customers to pay you. While you may be used to checks, they are among the slowest and least efficient ways to get paid. They’re also a hassle for both the recipient—who needs to wait for them to arrive, go through the reconciliation process, and walk to the bank to deposit them—and for the customers who need to manually write them, handle postage, and worry whether they will arrive on time.
Using an online accounts receivable (AR) platform like Melio, you can give your customers better choices without affecting how you get your money. They can choose to pay via bank transfer, debit card, or even credit card, according to what works best for their business and existing workflows. You will get the money directly to your account, via ACH bank transfer.
Just by offering better choices and an easy payment process that can be completed from anywhere, you are making it more likely for customers to pay sooner.
Improve cash flow health
While maintaining cash flow health isn’t the same as having cash on hand, it’s definitely a good place to start.
Using an online tool to manage accounts payable (AP) and AR is a great way to improve cash flow. Digital payments provide greater visibility and control over every payment coming in and out of your account, so you’re never spending more than you can.
Another way to improve oversight is to use apps to predict your cash flow. These tools allow you to see what impact each payment you make has on your cash flow, and simulate the effect of various payment terms and methods.
Make sure you’re not overspending
While the old saying is true—you need to spend money to make money—that doesn’t mean you don’t need to examine what you’re spending it on and where you can save some.
A good place to start is by checking if you’re eligible for any discounts or special offers from your vendors. Maybe you’re spending a large enough amount to deserve a bulk discount, or you’re paying early, or maybe they just value your relationship with them so much that they’re willing to accommodate you. Either way, you’ll never know if you don’t ask.
Another good practice for saving is to periodically examine your subscriptions and purchases to make sure you’re not paying for something you don’t need. This can be anything from a coffee bean subscription to design software you only used once to create a pamphlet but continue to pay for annually.
And, you can also eliminate unnecessary bank transfer fees by switching to an online business payment platform, like Melio, that offers free ACH bank transfers.
Let your money work for you
Especially with the fear of inflation looming, letting your money just lie around isn’t the best way to save. If you can, deposit some of your cash into a high-interest saving account so it continues to grow and does not depreciate in value.
Before you do that, however, check the terms of the account to make sure the funds can be liquidated quickly if you need them.
Cash is always king
Even when things are going well you shouldn’t be tempted to neglect your cash reserves. Sign up for Melio to keep a closer eye on money coming in and out of your account and ensure your cash is always flowing in the right direction.
*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.