Too Much Cash? How to Invest Your Small Business’s Extra Cash
June 30, 2021 | Last Updated on: February 21, 2023
June 30, 2021 | Last Updated on: February 21, 2023
Do you think your small business has extra cash?
If so, you should give yourself a pat on the back. According to JPMorgan Chase, the median small business holds just 27 cash buffer days in reserve.
You may be tempted to put the excess cash in your savings account and leave it for a rainy day. As 2020 showed, you never know what the future has in store. That wouldn’t be a terrible move, but it’s actually riskier than it seems because there is a good chance that we will see high inflation over the next few years.
In May, for example, the Consumer Price Index (CPI) rose 5% from a year earlier. That means any cash you’ve held over the last year is now worth around 5% less. That may not sound like much of a loss, but if that rate of inflation continues for a few more years, it would be devastating to a large cash balance.
So, what should you do with your excess cash?
We’ll answer that question in a bit. But first, let’s establish how much cash you should keep in your business bank account.
We can all agree that 27 days of cash isn’t enough. But how much is enough?
The standard advice from financial experts to small business owners is to keep cash reserves equal to 3-6 months of expenses. That’s a good starting point, but the answer is different for everyone based on their unique circumstances. For some, three months should be adequate. For others, even six months of expenses would be too risky.
Your business cash needs will vary based on the following considerations:
Let’s say your business expenses have averaged $40,000 a month over the last year. In that case, you should keep $120,000 to $240,000 of cash on hand, right? Maybe not.
If you expect your expenses over the next year to be $60,000 a month, you should use that to calculate your starting point. With $60,000 a month in expenses, the 3–6-month rule would indicate that your cash needs are $180,000 to $360,000.
It’s all well and good if you can project your expenses with reasonable certainty. But what if you can’t come up with short-term expense projections? Maybe you have a variable interest rate loan. Or perhaps one of your key raw materials fluctuates in price a lot.
If you don’t know what you’ll be spending, you should err on the side of caution and build up a larger cash position.
While the 3-6-month rule is based on your expenses, the riskiness of your incoming cash flows (sales) heavily impacts your cash needs. Here are some questions to ask yourself:
To go a little deeper on that last point: you can actually look at your business performance during past downturns to ascertain your cash needs. Let’s say your business burned through four months of cash reserves during the Great Recession and six months of cash reserves to get through the pandemic. In that case, you should keep six months of cash – at the very least – in your business bank account.
Unfortunately, there’s no formula to give you a precise amount that you should keep in your cash reserves. But by considering the above factors, you can come up with a number that makes sense.
If your revenue and expenses are both highly variable, for example, you might want to keep six months of expenses in your bank account – or more. If, on the other hand, your business has turned a profit for 25 consecutive years, three months of surplus cash may be sufficient.
What if your situation isn’t clear-cut? Or if you or your management team is overwhelmed by the data? In either of those cases, you may want to consult with a Certified Public Accountant (CPA) to help you figure out how much extra money you should keep in your bank account.
After deciding how much cash and cash equivalents you’d like to keep on your company’s balance sheet, it’s time to come up with an investment plan for the rest of it.
There are two categories of investment options for your company’s cash: investments in your business and other income-producing assets.
Amazon has become a trillion-dollar company for a lot of reasons, but perhaps the biggest reason is that Jeff Bezos was always re-investing his profits into the company. A trillion-dollar valuation may be out of reach, but small business owners can also invest their excess cash to take their business to new heights.
Here are some of your options:
Your business might need real estate or equipment to help grow sales. With your excess cash, you can make a down payment – or purchase the asset without financing. The decision to take on debt shouldn’t be made lightly, but in an inflationary environment, you may actually come out ahead if you get a fixed interest rate loan – you’ll be making the same monthly payments with increasingly worthless dollars.
If there’s an up-and-coming company that you feel would perfectly fit into your existing business, you don’t necessarily have to watch from the sidelines – you could make an offer to buy the company. Depending on the size of the business this could get expensive, so you may need to have a lot of excess cash. But this is an excellent way to increase your market share.
The only constant is change. There is more change in some industries than others, but in any industry, a stagnant company is a sitting duck. With that in mind, you may want to devote some of your extra money to launching new products. In order to successfully launch a new product, you may need to hire more staff, invest in equipment, and run a marketing campaign.
In the absence of high return on investment (ROI) business investments, you can turn to other income-producing assets to put your excess cash to work. Your portfolio decisions will be impacted by your risk tolerance and short and long-term goals. At one end of the spectrum, you have MicroStrategy borrowing $600 million to buy Bitcoin. To do something like that would require a high confidence in future cash flows and a huge risk appetite, so it’s not advisable for the vast majority of small business owners.
But there are other options that provide excellent returns – and not nearly as much risk.
A money market fund invests in very short-term debt. The funds are designed to offer investors high liquidity and extremely low risk. But that safety comes at the cost of returns, particularly in our current low-yield environment.
If you want to protect yourself from inflation without investing in a volatile asset, treasury inflation-protected securities may be your best bet. They are indexed to inflation, adjusting in price as inflation rises to maintain their real value.
The bond market has something for everyone. If you want safety, you can invest in treasuries. If you want a higher rate of return – and you’re willing to tolerate more risk – you can opt for foreign government or corporate bonds.
Over long periods of time, few investments have matched the returns of the stock market. But those higher returns are accompanied by higher risk. The stock market has quickly lost one-third (or more) of its value on a number of occasions, and investors should expect similar volatility in the future.
To find the right mix of investments, you may want to talk to a financial advisor. By doing that, you can balance your short and long-term needs with your risk tolerance to find the optimal portfolio for your small business.
Whoever said “cash is king” was right; it’s extremely important to have cash on hand. But at the same time, you don’t want to keep too much cash on hand. There is not only the risk that inflation will erode the value of your cash, but also the opportunity cost of lost business growth or investment income.
By coming up with the right strategy, though, you can give yourself security and upside potential.
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