When it comes to cash flow management and planning, a good question to ask is “how much cash should a business have in reserve?” The answer to this depends on the cash conversation cycle of a business, but if you’re looking for a short answer without having to read everything below, let’s go with 10% - 15% of gross revenues. This should help reduce possible cash constraints that your business may be experiencing. Now let’s explain why that is, by better understanding the Cash Conversion Cycle.
The Cash Conversion Cycle of a business measures how long it takes (in days) for a company to convert its non-cash assets into cash, and is a good metric to determine how a business manages its working capital, which is the capital needed for ongoing operations.
The formula below shows how Cash Conversion Cycle is calculated:
Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding
Diving Into The Formula
If you are unfamiliar with some of these terms, here they are as defined by some of your financial statement line items:
Days Inventory Outstanding (DIO) = (Average Inventory / Cost of Goods Sold) x Number of Days in Period
This measures how quickly inventory is turned over (how many days it takes to sell inventory).
Days Sales Outstanding (DSO) = (Average Accounts Receivable / Total Credit Sales) x Number of Days in Period
This measures how quickly a business collects on its outstanding Accounts Receivable (converting receivables into cash).
Days Payables Outstanding (DPO) = (Average Accounts Payable / Cost of Sales) x Number of Days in Period
This measures how quickly a business pays its outstanding Accounts Payable balances.
A couple of other helpful tidbits here, in case you’re looking to do some of your own calculations:
If you need to calculate your Cost of Goods Sold, it’s equal to your Beginning Inventory + Purchases for the Year – Ending Inventory. It's also typically found on your Income Statement.
When you see the word “Average” used above it means the average of the current and prior period balances per your financial statements.
The term period refers to the amount of time you are measuring. This is often annual, but can often also be semi-annual, quarterly or monthly.
Inventory may include raw materials inventory, finished goods inventory, and even Work In Progress (WIP), which is common in the construction industry.
Getting Back To The Main Point
So, let’s recap what we are looking at here. The Cash Conversion Cycle looks at how quickly inventory is turned over and converted to cash (typically through selling inventory, or billing out your WIP), how quicky Accounts Receivable are collected, and how quickly Accounts Payable are paid. The larger the Cash Conversion Cycle for a business, the longer cash is typically tied up in inventory, WIP, or Accounts Receivable. When cash is tied up for a longer period of time, it is important to have a greater amount of cash in reserve, in order to avoid cash constraints.
So, how did we come up with 10% - 15% annual revenues for a cash reserve target? This is based on determining what your daily revenue is, and then multiplying that by how many days cash is tied up (that is, your Cash Conversion Cycle), and this will give you a good idea of how much cash you should keep on hand to avoid a cash constraint.
The linked excel file has a model that you can use to look at your own cash conversion cycle. It’s prefilled with numbers that you might find in an established small or medium sized business. From this model, you can see that a cash reserve of 9.7% of annual revenue would be recommended for a cash reserve. Another way of looking at it is that you would need just over one month of revenues in cash reserves (9.7% x 12 months).
Where To Take It From Here
Click here to download our cash conversion cycle model spreadsheet and see how the numbers look for your own business. The green highlighted fields are the fillable fields. Once you plug in your own numbers, you should have a good idea of how much cash your business should keep on hand – in reserve – at any given time in order to avoid future cash constraints.
We recognize that having cash reserves between 10% and 15% may not be where you are at quite yet. Not to worry. This is a target to set, and through ongoing cash flow management, you can get there. At BasePoint CPA, we understand the challenge of building a successful business with consistent cash flow. You're aiming for growth but may feel uncertain about where to start or how to get there. We're here to guide you. Through monthly Zoom calls, we provide a clear roadmap for you, using a tailored scoreboard based on your financials and forecasts. With specific, actionable steps, you'll move toward reliable cash flow and a thriving business. Along the way, you'll gain a deep understanding of the key drivers of cash flow and profitability, empowering you to confidently steer your business toward success.
If your business could benefit from monthly guidance, much like a navigation system for your business, helping you understand where you are relative to your business goals, how on track you are and the route you should take to reach them, with clear actionable steps to keep you on course, please schedule a Zoom call with us today to discuss further.
People often enter into business because they are good at what they do, but face challenges as their business grows. At BasePoint CPA, we serve as your experienced financial guides, so you can have confidence with regular financial insights and the ability to make informed strategic decisions.
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The information above is intended to be of a general nature, and is not intended to address the circumstances of any particular individual or entity, and is not able to capture changes that may be enacted that would impact the information above following the date of publication. As such, there is no guarantee that the information above is accurate as of any given date following publication, and so no one should act on or make specific decisions based on the information above without first receiving professional advice that can take into consideration specific circumstances for each person. Should you wish to discuss your specific situation, you can contact us here.
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