Are congratulations in order? Or perhaps you're just thinking positively--I like it! If you're in the enviable position of having an excess of cash on hand, you have the power to take advantage of opportunities to invest in your business. But before we get to that fun topic, let me answer your first question.
Conventional wisdom holds that a business should have liquid assets (cash in bank accounts and very liquid investments) equal to three to six months of operating expenses. That's a nice rule of thumb, but I like to separate cash into a monthly operating account and a contingency fund. Put simply, the operating account should carry a sufficient balance to cover the lowest cash-inflow month of the year for your business. (Seasonal businesses should have enough cushion to last through both their busy and slow seasons.) It's your contingency fund that should equal three to six months of operating cash.
Here's how to calculate both.
- Analyze the last 12 months of costs, broken down into production costs (otherwise known as cost of goods sold in manufacturing or distribution businesses or cost of sales in service businesses), and overhead costs that are spent every month, regardless of sales volume.
- Take your current assets (bank balances, outstanding accounts receivable, inventory value) and subtract your annual liabilities (taxes due, accounts payable, loans payable in the short term), then divide by 365 to come up with your daily operating capital. Multiply this by the number of days to arrive at a contingency amount you're comfortable with.
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