What is a Cash Benchmark?
Cash benchmark is a unique metric because it represents a sweet spot. It helps business owners determine the ideal amount of cash they should have on hand to manage risk without leaving too much cash idle, which could be better used elsewhere.
The key question it answers is: How much money should we have available to operate smoothly, without running things too tight or being too conservative with cash?
IN THIS ARTICLE:
→ Calculating the Cash Benchmark
→ Too Little or Too Much: Finding the Balance
→ How Common is it to Hit this Target?
→ Influencing the Cash Benchmark
→ Practical Mindset: It's Not About Perfection
→ Final Thought: Cash Management is About Balance
Calculating the Cash Benchmark
The formula for the cash benchmark is straightforward:
- Three months' worth of fixed costs is the ideal cash reserve for a business
- This includes fixed costs of goods sold, overheads, and loan repayments.
For example, if your business has monthly costs of $100,000 (in overheads, fixed costs of goods sold, and loan repayments), the Cash Benchmark would be $300,000 (3x $100,000). This ensures you have a cushion for any unexpected events or downturns.
Too Little or Too Much: Finding the Balance
The cash benchmark helps business owners avoid two extremes:
- Too Little Cash: If you have less than your cash benchmark, you're running the risk of not having enough liquidity to manage the unexpected challenges, like a market downturn or industry disruption (think Covid-19)
- Too Much Cash: On the other hand, if you consistently hold more cash than needed, your capital may not be working as effectively as it could. Excess funds could be reinvested into your business for growth or returned to shareholders.
Find that balance is the key to maintaining a healthy financial position while also avoiding the trap of hoarding cash unnecessarily.
How Common is it to Hit this Target?
In reality, very few businesses achieve this cash benchmark consistently - perhaps only one or two out of every ten businesses.
But this isn't a cause for concern. It's rare to see businesses perfectly balance cash reserves because it's common to reinvest cash back into the business, especially during growth phases or when taking advantage of new opportunities.
The takeaway here is to aim for the benchmark but understand that it's more of a guideline, not an absolute rule.
Influencing the Cash Benchmark
How do you work towards meeting your cash benchmark? Here are some practical steps:
- Develop a cashflow plan: A solid cashflow plan helps you understand your financial needs without compromising your operations. This plan will also give you peace of mind, knowing you can meet your obligations while maintaining enough liquidity to sleep at night. See: How to Read Your Cash Flow Statement
- Reinvest for growth: If you find yourself consistently exceeding the cash benchmark, look for opportunities to reinvest that extra cash back into your business. Whether it's new projects, technology, or team expansion, that excess cash can drive future growth.
- Return funds to shareholders: If there are no immediate reinvestment needs, consider returning excess cash to shareholders. This is particularly important if you're not planning any major project expansion in the near future.
Consulting with a tax accountant can help ensure that returning funds to shareholders is done in the most tax-efficient manner. Additionally, by hiring CFO dynamics as your Outsourced CFO, we can do all this for you, saving you the time and mental stress!
Practical Mindset: It's Not About Perfection
Reaching your cash benchmark is a useful target, but don't stress if you're a little above or below the ideal number.
- If you're slightly above the benchmark, don't feel guilty about having 'lazy' cash - just look for ways to make that money work smarter
- If you're slightly below, that's not necessarily bad either - it might mean you're putting your cash to work through reinvestments into the business, which is often a smart move in the right circumstances.
Final Thought: Cash Management is About Balance
In conclusion, the cash benchmark is a helpful guideline that ensures you're not running your business too tightly or holding on to excess cash unnecessarily. It's about balance - having enough to weather storms but also making sure your money works hard for you. Develop a clear cashflow plan, reinvest wisely, and if there's excess cash with no immediate need, consider returning it to shareholders.
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