Does Your Business Have Enough Cash to Survive a Downturn?You should have anywhere from two to eight months of cash burn reserves depending on your situation.
In all of my business years, whether consulting, advising or simply observing, there has been one constant with small businesses: Just when you think you have it all figured out and can finally breathe for the first
time, your operating environment changes overnight.
Whether it’s due to a macro-level economic event that hammers everyone (like the dot-com crash or the Great Recession) or a business-level matter that spirals out of control (such as the loss of key management), these types of events are often sudden and violent and can be very painful if your business is not prepared.
So ask yourself: “Does my business have the financial strength or more important, the necessary cash, to weather the storm?”
To answer that question, you’ll need to identify a reasonable level of cash that will support continued operations in good times and bad. Start with these five steps.
Related: How to Survive a Cash Flow Crisis
1. Use CART financial statements. CART stands for complete, accurate, reliable and timely. To understand how much cash you might need, you must first understand your starting point (how much cash do I have) and base economic model (how is cash generated and consumed in your business).
2. Develop and use a weekly or even daily cash or liquidity “flash” report. Flash reports are designed to report critical business operating data over very short periods. A daily or weekly sales summary is a perfect example of a commonly used flash report.
3. Know your worst-case burn rate. This is the average periodic negative cash flow your business would incur in a poor or worst-case operating scenario — how much cash you would burn each week, month, etc. Monthly sales of $45,000 and monthly expenses of $65,000 produces a burn rate of $20,000 per month.
4. Know how many months of runway you have. Based on your current adjusted cash balance (what you have plus any expected receipts less any payments), how many months of life or “runway” do you have given your current monthly burn rate? If your adjusted cash balance is $60,000, at a burn rate of $20,000 per month your business would have three months of runway. How much would you have assuming your worst-case burn rate?
5. Know your quick ratio. Most people understand the current ratio (current assets divided by current liabilities). A healthy current ratio is above 1.5X and ideally closer to 2.0X. More important to managing cash (and more conservative) is your quick ratio: current assets, less non-liquid current assets including inventory and prepaid assets, divided by current liabilities. A quick ratio well north of 1.0X is ideal.
How much cash you need to survive a crisis will depend in part on how predictable your sales and expenses are and whether most of your costs are variable (and can easily be reduced if problems arise) or fixed (such as rent). The more predictable your business model and the more active your control over your expenses, the quicker you can pivot if trouble arises, which means you should be able to work through problems with a lower cash balance.
In short, how many months of cash you need
If your financial performance is unpredictable or volatile and you have a high level of fixed operating expenses, a relatively low quick ratio (less than 1.25X) and weak internal reporting, you’ll need a higher cash balance to weather a major storm — a minimum of four months of cash burn reserves and probably closer to eight.
On the other hand, if you have a very predictable business model, can quickly adjust operating expenses, have a solid quick ratio (greater than 2.00X) and strong internal reporting, a range of two to four months of cash burn reserves should suffice.
Remember, when you need cash the most is when it’s hardest to get. So it’s always advisable to be conservative and build added cash reserves. Without question, one of the most common reasons small businesses fail is due to being undercapitalized.
Editor’s note: Tage Tracy is a financial consultant and co-author of several books including “Cash Flow for Dummies,” “How to Read a Financial Report” and “Small Business Financial Management Kit for Dummies.”