Every business needs some degree of liquidity in order to carry out its day-to-day activities. Having some cash on hand will allow you to pay your bills, settle payroll and be prepared for any unexpected occurrences.
A general rule to bear in mind is that the cash flowing into your business must be greater or equal to the cash flowing out.
Importance of a cash reserve
If your business continues to function on a negative cash flow, it will eventually go insolvent. This is, of course, the worst case scenario.
Examples of issues that may lead to negative cash flow include a big client not paying their invoice or a significant decline in sales.
Negative cash flow can be temporarily overcome by taking cash out of your reserves or selling assets, but the root of the problem needs to be resolved before you empty out your bank account.
Instead of focusing solely on having enough cash on hand to meet your obligations, it would be a good idea to prepare a cash reserve as a safety net for your business to avoid insolvency.
Having some cash on hand will give you some time to make adjustments to your business in case anything goes wrong.
How big should your cash reserve be?
The size of your cash reserve would depend on the type of business you run and how volatile the market is.
If your business operates in a stable market, you would be safe with a cash reserve worth a few months of your obligatory payments.
If your business operates in a volatile market, you would need a cash reserve to last you through six months or more to be safe.
Generally, holding an amount of liquid assets that goes slightly over what is deemed a safe amount is alright. However, there are good reasons why you should not have too much cash on hand either.
What to do with excess cash?
If you are not smart with the way you use your cash, your business may end up overspending on inefficient costs. These risks are difficult to avoid unless you do enough forward planning.
Even if you plan ahead and are frugal with your business’ cash, it is still inefficient just to keep excess cash on hand.
Instead, investing the capital in growing your business or returning it to shareholders to explore other ventures would be the smarter way to go about this.
Should you decide to return the capital to shareholders, it could be returned as a dividend or by repurchasing your company’s shares.
You may also consider building a war chest for your business, which is a fund that can be used to grow the business organically in uncertain times or through acquisitions.
A good amount of liquidity is essential for all businesses to stay successful. Make sure to put in the necessary time and effort to plan your business’ future.
PAQ Group specialises in all things bookkeeping including GST, PAYG and other related taxes. We understand the struggles that small businesses have with cash flow and arranging investments.
We are confident that we will be able to assist you with any issues you may be encountering in your business. We do this by providing up-to-date bookkeeping, regular catch-ups, and the steps you can take to optimise your business operations.
If you need any help with your business’ financial planning, please do not hesitate to contact us on our website.