Going into the Global Financial Crisis, one of our customers was sitting on enough cash to get them through eight months with no sales. The cash alone was the end of their business.
Every business needs the right mix of cash reserves to get them through a tough patch, alongside enough pressure to keep them pushing. Unfortunately for our customer in the GFC, the cash let them be lazy. They could sit back and wait for the GFC to end – wages were covered so no pressure…right?
Eight months in though and they had hardly any work. They had too many staff. Their operating costs were too high. And then they realised that their cash was running out. Panic sets in and they pull the pin.
How much cash do you need?
This is an answer we hate giving, but, it depends. It depends on things like staffing levels, working capital cycle, debtors, sales cycle, and job turnaround times. While there is no rule of thumb, we do have a consistent way we think about it with customers.
If it takes you a month to sell your product, then you need one month’s cash as a bare minimum. So, that would be enough cash on hand to cover one month’s wages, cost of sales and operating costs.
For a more robust way of looking at it, we’d recommend you map out your working capital cycle. This works out how many days it takes $1 of cash to spin through your business. You’d then make sure you’ve got enough cash on hand to survive that many days.
However you calculate how much cash you need, make sure you know your number. With that, that put your GST aside, put your tax aside, and put aside an amount for any capital purchases. Then ideally you’ve got a buffer you could pull out.
When to pull it
There are two schools of thought. The first is pull the extra cash whenever it’s sitting there. The second is pull it once or twice a year as a lump sum.
Pulling it whenever it’s there gives you more opportunity to use the cash outside of your business for investing or debt reduction. Then if your business needs more cash you’ll be forced to reinvest in the business – letting you evaluate the decision to reinvest in the same way as a bank
Pulling it once or twice a year lets you ride out the seasonal peaks and troughs your business experiences. It also gives more flexibility to reinvest and expand your business as needed.
For Convex, we pull our extra cash once or twice per year. This lets us get through our seasonal trough over January and February, and helps us manage the growth of our business. It works for us, but doesn’t mean you should necessarily take the same approach.
Whatever approach you take just needs to be deliberate and planned – not just putting your hand in the metaphorical money cookie jar whenever you like as business owner.
How Covid changes things
Covid and the general downturn across the economy shouldn’t change how you think about pulling money out of your business.
Sure, there may be less to pull out. Yes, you might want to hold more in reserve (for example cash for one and a half months instead of one month). But the arching logic is the same. Know how much you need and come up with a plan for when you pull the extra.
Would less cash have been different?
For our customer with eight month’s cash going into the GFC, things would certainly have been different if they had less cash in the business. It’s always easy with hindsight, but they had the worst possible outcome.
They burnt through their cash, simply to avoid making the hard decisions, and still ended up closing the business.
If they had had less cash, then they still may have ended up shutting down. They would have burnt through less cash along the way.
Alternatively, less cash might have encouraged them to think about their options sooner. They might have restructured. Found new markets to sell into. Found new ways to sell.
Ultimately their significant cash reserves insulated them from dealing with the situation. The takeaway – know what cash you need. Have a plan for drawing the excess.
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