Cash: How Much is Enough?
The good news is that there are a number of companies with strong cash positions. Their
question is, “How much cash should a company keep on hand?” Every small business owner
dreams of having a large enough bank account that they will need to address this question.
In this paper we will consider the factors in determining the optimal cash level for the small,
private company. These factors include: 1) liquidity needs, 2) required reserves, 3) expansion
opportunities, 4) loan covenants, and 5) the availability of credit.
The optimal cash level summary:
Assume all funding will come from cash reserves.
1. Know the cash cycle and seasonal requirements.
a. Basic cash requirements to meet normal cash cycle.
b. Project the working capital requirements for seasonality to see maximum
cash needs.
2. Estimate 3 months cash to cover expenses in worst case.
3. Estimate potential expansion options.
4. Review loan covenants for covenant coverage.
The sum of 1 to 3 is the targeted cash reserves, with #4 being an outside commitment.
Return extra to shareholders.
Liquidity Needs:
Liquidity is defined as “the ability to convert an asset to cash quickly”1 and the ability to meet
obligations when they come due over the next year. It was liquidity that killed Lehman Brothers,
not lack of equity. Therefore, understanding liquidity is the starting place for determining how
much cash to keep on hand. Liquidity involves the cash cycle and other resources or reserves
to meet cash requirements.
The cash cycle is the business cycle of working capital. Understanding the cash cycle helps to
anticipate the length of time it takes for working capital to become cash. For a company with
inventory that sells on account, the cash cycle will start with the need to pay for inventory, which
depends on the vendor’s accounts payable policy. Next is the time it takes for the inventory to
be sold to create accounts receivable. The accounts receivable collection period is the final
step in the cash cycle. An example could be inventory has a immediate supplier payment
(COD), inventory takes 30 days to be sold (stocking and selling on average), accounts
receivable invoices go out immediately and take 30 days to collect, collections are deposited
immediately and funds are available on deposit. Result is a 60 day cash cycle. It should be
clear that at each point, the cash cycle could be longer. The question is whether it can be
shorter. Speeding each collection step will reduce both the time and the required working
1
www.investopedia.com
Cathedral Consulting Group, LLC
Page 1
capital. Actions to minimize working capital are covered in other Cathedral Cash Management
Topics of the Month.
Seasonality analysis shows the needed working capital and primary cash reserves to cover
working capital growth during the year. A great example of forecasting cash flows and the
importance of working capital can be found in Cathedral’s paper “Budgeting Revenues to Cash
Flow” here. Current market conditions should be factored into this analysis by doing a best
case, normal case, and worse case scenarios.
Required reserves:
Once the liquidity needs have been determined, then the level of reserves is evaluated.
Reserves can be described as the comfort that is needed if things go wrong. There are rules of
thumb, such as (a) 3 months of expenses = rainy day; (b) 4 – 6 Months of expenses = sleep like
a baby; or (c) 6+ months = gambling fund.2 The key is that in a downturn scenario (or worst
case forecast), the company should have adequate liquid reserves to enable the business to
continue operations for a minimum of 12 months, after factoring reasonable actions to minimize
expenses. Note that Accounts Receivable may not be considered liquid in this scenario as
collections may be difficult to obtain in a downturn situation.
Expansion opportunities:
Expansion opportunities can arise at any time. In more troubled periods, acquisitions will arise
with greater frequency because of both operational and financial stress. These can be very
valuable opportunities with attractive pricing. Having cash reserves for opportunities that come
is strategically useful. How much cash would be required depends upon the opportunity.
Generally, one can look at the types of opportunities that a company can pursue and ball park
the needed cash. For example, a company with $5 million in revenue will generally consider
acquiring a company with under $1 million revenue. The price-tag will generally be less than
one times revenue with some amount down and a pay-out over time. Therefore, the cash is the
down payment plus transition cash requirements.
Loan covenants:
Existing loan covenants may contain restrictions on cash distributions or levels of equity.
Therefore, covenants should be evaluated to see if they allow for excess cash.
Total cash requirement:
At this point we have a level of cash needed to operate the business for the near future,
including reserves and opportunities. Cash balances in excess of this amount can properly be
treated as excess cash.
Factoring in available credit
Beyond excess cash, the available credit, such as credit lines, must be considered. (A full
treatment of the role of credit lines is beyond the scope of this paper.) Relative to this topic, a
company needs to adopt a view of whether it will be an “all cash” or a “cash plus line of credit”
operated company. We would like to note that business school professors will talk about cost of
capital and limiting the shareholder’s investment in a company in order to maximize the return
on investment. What Cathedral sees in our private companies and what we recommend is a
higher focus on maintaining cash and paying off debt. Private companies have severe limits on
2
Warrillow, John. “Cash cushion: how much to keep.” The Globe and Mail. 24 Aug. 2011.
http://www.theglobeandmail.com/report-on-business/small-business/sb-money/cash-flow/cash-cushion-how-much-tokeep/article2117164/
Cathedral Consulting Group, LLC
Page 2
credit. Private companies need to be able to survive on their own at all times. This makes
Cathedral a fairly conservative capitalization oriented firm.
A company may adopt the strategy of using a line of credit to backstop available cash. In such a
case the line is treated as available liquidity, adding the unused balance to cash for comparison
to the needs determined above. However, it is important to recall that in 2009 and 2010
tightening credit markets caused banks to cancel lines of credit, even for those companies that
had always been current. A line of credit should also be applied for before the need for one
exists. Banks will not loan to a company when it is in need of additional credit and the approval
process for a credit line will take four to six months. In short, Cathedral cautions against
counting on credit lines.
What to do with excess cash?
Excess cash is a blessing. Keeping it in a private company is not recommended because the
purpose of a limited liability company, both corporation or LLC, is to prevent creditors from
reaching assets that are not part of the business. Only the amount of cash needed to operate
the business should be kept in the business and available to creditor claims. Clearly, there are
tax implications to taking money out of the company, but those are beyond the scope of this
paper.
If the owners of the company have good financial disciplines, Cathedral would encourage
reserves to be held at the shareholder level and advanced to the company when need or
opportunities arise.
Action Items
1. Review the optimal cash level summary utilizing your company’s financials to determine
if there is excess cash that should be distributed to shareholders.
Tutorials & Articles for Further Reading
McLannahan, Ben. “Cash: How Much is too Much?” 01 Mar 2003.
http://www.cfo.com/article.cfm/3008806?f=singlepage
Warrillow, John. “Cash cushion: how much to keep.” The Globe and Mail. 24 Aug. 2011.
http://www.theglobeandmail.com/report-on-business/small-business/sb-money/cash-flow/cashcushion-how-much-to-keep/article2117164/
King, Stephen. “How Can I Create a Reliable Cash Flow Budget?” 09 Aug. 2000.
http://www.inc.com/articles/2000/08/20058.html
Phil Clements is CEO of Cathedral Consulting Group, LLC and a Managing Director in the New York
Office. Sharon Nolt is a former Senior Associate in the New York Office.
For more information, please visit Cathedral Consulting Group LLC online at
www.cathedralconsulting.com or contact us at info@cathedralconsulting.com.
Cathedral Consulting Group, LLC
Page 3