In today’s uncertain marketplace, many businesses are stashing operating cash in their bank accounts, even though they might not have imminent plans to deploy their reserves. However, excessive “rainy day” funds could be an inefficient use of capital. Here’s a systematic approach to help estimate reasonable cash reserves and maximize your company’s return on long-term financial positions. 

What’s the Harm in Stockpiling Cash?

An extra cushion helps your business weather downturns or fund unexpected repairs and maintenance. But cash has a carrying cost — the difference between the return companies earn on their cash and the price they pay to obtain cash. 

For instance, checking accounts often earn no (or very little) interest, and many savings accounts generate returns below 2%. If a company has cash reserves while simultaneously carrying debt on its balance sheet, such as equipment loans, mortgages and credit lines, it will pay higher interest rates on loans than it’s earning from the bank accounts. This spread represents the carrying cost of cash. 

What’s the Optimal Amount of Cash to Keep in Reserve? 

Unfortunately, there’s no magic current ratio (current assets divided by current liabilities) or percentage of assets that’s right for every business. A lender’s liquidity covenants are just an educated guess about what’s reasonable. 

However, you can analyze how your company’s liquidity metrics have changed over time and how they compare to industry benchmarks. Substantial increases in liquidity — or ratios well above industry norms — may signal an inefficient deployment of capital. 

Prospective financial reports for the next 12 to 18 months can be developed to evaluate whether your company’s cash reserves are too high. For example, a monthly forecasted balance sheet might estimate expected seasonal ebbs and flows in the cash cycle. Or a projection of the worst-case scenario, based on certain what-if assumptions, might be used to establish a company’s optimal cash balance. Forecasts and projections should take into account a business’s future cash flows, including capital expenditures, debt maturities and working capital requirements. 

Formal financial forecasts and projections provide a method for building up healthy cash reserves. This is much better than relying on gut instinct. You also should compare actual performance to your forecasts and projections — and adjust them, if necessary. 

What’s the Highest and Best Use of Excess Cash?

After prospective financial reports and industry benchmarks have been used to determine a company’s optimal cash balance, management needs to find ways to reinvest its cash surplus. For example, you might consider repurposing the surplus to: 

• Invest in marketable securities, such as mutual funds or diversified stock-and-bond portfolios
• Repay debt to lower the carrying cost of cash reserves
• Repurchase stock, especially when minority shareholders routinely challenge management’s decisions
• Acquire a struggling competitor or its assets

With proper due diligence, these strategies could allow your business to reap a higher return over the long run than leaving funds in a checking or savings account. 

We Can Help

Doeren Mayhew's pros are here to help create formal financial forecasts and projections and evaluate benchmarking data to devise sound cash management strategies. We can guide you toward a more efficient use of capital, while reserving enough cash on hand to meet your business’s short-term operating needs.