Here’s a fact: 2020 has been a tough year and some businesses haven’t made it because they’ve been shut down or their revenue dropped off significantly for weeks or months.
The reality is that there are always ebbs and flows in the economy, and you could have a down month, quarter, or year at any time. If that were to occur, what would happen to your business?
I know that’s a stressful thought, but you can plan ahead and set the odds in your favor by saving up a cash cushion.
What’s a cash cushion?
A cash cushion is extra money that you have sitting in your business accounts to use if you hit tough times. Much like having a personal savings account, you can tap into your cash cushion if your revenue is down or if you have an unexpected expense come up, and help keep your business afloat!
Some people may call this cushion “working capital,” but this is really not the same thing. Working capital is what you have left of your liquid assets (if you collected all your accounts receivable and sold all your inventory) after paying all your current liabilities (vendor bills, credit cards, payroll, etc.). What we’re talking about today is just cash, since that’s easiest to access in a pinch.
You might also have a line of credit (LOC) or a business credit card, which is also a good idea. We like LOCs because you can quickly get cash when you need it, but remember that if you use your LOC, you’ll have to pay that money back and will incur interest.
How much of a cash cushion should you have?
There’s no one-size-fits-all answer, but in general you should aim to save three to six months of expenses. Three months is probably adequate for most businesses, but if your revenue is volatile, if your business is more heavily impacted by swings in the economy, or if it would make you feel more at ease, then you may want to save closer to six months.
Focus on saving for the expenses that won’t go away if your revenue declines. This includes things like rent, loan payments, payroll for salaried employees, employee benefit expenses, insurance, and other contracted payments.
Some expenses will decline if your revenue dips, so you may not need to save for those. An example is inventory costs – if you have a decrease in sales, then you probably won’t need to buy inventory. Hourly employee costs could also decline if you stop staffing your business, but may not decrease to zero if you have to maintain a minimum level of staffing at all times.
Other expenses, like memberships, outsourced labor, subscriptions, and travel may be nice to have but not necessary, so you can probably cut a lot of those expenses if you are in dire straights.
Can you have too much cash?
Yes, it is possible to have too much cash! Having a huge cash balance means that you’re not investing your profits back in your business, whether you want to run marketing or redo your website or buy some new equipment. When you generate profits, you need to make sure you’re reinvesting wisely.
You also need to make sure you’re using some of that money to cover any income taxes you might owe. If you’re able to generate cash, then you’re probably going to incur taxes.
Last, having a huge cash balance can make some people overspend on things they don’t need, so keep tracking your spending and budgeting to make sure you’re spending wisely.
Just remember to balance your need for savings with your need to reinvest and pay yourself.
3 steps to saving up a cash cushion for your business
Step 1: Understand your monthly income and expenses by keeping up with your books. This will allow you to understand how much you spend in a typical month. Also, once you know what your profits are, you can plan how much money you’ll allocate to savings, how much for reinvesting, and how much for taxes and paying yourself!
Step 2: Calculate your cash cushion requirement. Maybe start with a minimum goal of saving three months of the really necessary expenses. Once you reach that, set another goal of saving for six months, or increase to cover the nice to have expenses.
Step 3: Put money aside in a business savings account and get your cash cushion built up as quickly as possible.
What’s the biggest barrier you have to saving up your cash cushion?