Plan for the Worst; Hope for the Best
Now we are coming out of the recession, I think I can say I have become convinced of one thing. Building up a cash reserve for my businesses was the best thing I did for myself. I learned early in my life that few habits would serve me better as an adult was the habit of saving money. I look at what companies have flourished in the recession, and I see that they all have done the same thing: building up cash reserves and paying down debt. Microsoft and Verizon have both done this, and you can see how they have repositioned themselves as competitors again. They have released new products that seemed to be running second best to the competition, Apple and AT&T. You can do this too.
Saving Up for a Rainy Day
Too many small business owners operate their business similar to their own household. That is to say, from week to week. The operation of a household is a whole other conversation, but even there, the basic wisdom is to have three months of your income set aside for large or unexpected costs. In that way, a business is not so different. The problem is that there is too much at stake to operate a business in this way. You just can’t figure it will come together in the end. Without a cash reserve, your business runs the risk of becoming a casualty if there is an unexpected bump in your cash flow.
If you are a seasonal business, take a fair chunk of your profits in the busy season and set it aside for the slow season. Retailers that do well during the holidays should put money aside that will be liquid during the summer. Alternatively, lawn care or building companies should store up reserves for the winter when jobs are few and far between. If you are fortunate to have steady business year-round, take 10% of your profit and use that money to reinvest in your business by advertising, updating computers, or building up your staff.
How Much Cash Do You Need?
This is the $1,000 question. To keep things simple, Sam Ashe-Edmunds of Demand Media writes:
Determine how long an interruption in cash flow is likely to occur, calculate your costs to keep doing business during that time, subtract any credit or other assets you are willing to use and determine your cash reserve needs.
Take the longest period of time you can expect to be without a solid cash flow. Let’s say 3 months. Calculate two numbers: Operating Costs and Overhead Costs: Operating costs are the cost of doing business. This can include the cost of producing a product, the cost of inventory items, etc. The overhead costs will be your lease/rent, utility bills, wages, etc. Add these up for a 90 day period of time, and that should be your cost reserve. Pro Tip: be aware of the fluctuation of these costs throughout the year by taking into account like the cost of heating and gasoline in winter vs. AC in summer. Overhead can spike at certain points in the year when business is slow, so include that in your projection.
Build Up Credit and Find Opportunities
I may sound like a broken record, but you must build up your credit at times when you don’t need it. If you have a great quarter, go to the bank and apply for more credit based on your potential to grow. Have enough credit to get you through at least two slow cycles.
If you never end up needing the cash or the credit, you have just saved enough money to make your business more competitive. You can use surplus reserves to pay down debts, buy other companies, or open new branches. This is what the most successful companies during the recession have done.