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All of the recent volatility in the markets and the world in general got me thinking…the US economy has been pretty vibrant and on an upward trend for a fairly long while, and eventually, the business cycle will come full circle, it always does.  Considering that they tend to happen every 7-10 years on average, chances are we will see one sooner or later.  Some economists predict the next one is just a couple of years away.  There also seems to be a growing sentiment that the Coronavirus situation will push the economy into recession.  Maybe it will, maybe it won’t, but one thing is for sure, business leaders everywhere are reviewing their situations on plotting the next move.   I know I am…..

We have probably all heard the saying “Cash is King.”  I am personally a big believer in this because of the biggest thing, in my opinion, that a healthy cash reserve buys, is freedom.  Freedom to grow the business, freedom to hire that rock star A player, and in the case of a downturn, freedom to weather the storm without panicking.  Whatever your business model, keeping a cash reserve can create a huge advantage in your business.  While your competitors are struggling, your business can soldier on, taking care of customers and riding out the rough patch.

Saying that a cash reserve is important is not news, it’s not revolutionary, and it is certainly not as if I came up with the idea myself.  It is not hard to get consensus that having a cash reserve is a good idea.  The big question is “how much is enough?”.

Cash Reserve Planning – What Does My Business Need?

Writing this post has been almost like therapy.  I had to come up with a way to sort this issue out in my company, and it wasn’t easy.  Scanning the Internet for answers yielded as many opinions as there were articles, and here I go adding yet another one to the digital pile.

Most of what I read suggested some multiple of monthly expenses, or a percentage of revenue, etc.  None of them were bad ideas, but when I started running the numbers, it felt like there was going to end up being a lot of capital just sitting idle, waiting for doomsday. That didn’t feel super great to me.  Cash is not easy to come by, so parking it in a savings account, or even a money market account in large sums seemed wasteful.

I started thinking about it another way.  If I am planning for a bump in the road, then maybe defining what the bump is would be a good start.  It seems to me there are 2 issues to consider:

  1. How long could the rough patch last?
  2. How big of a reduction in sales could reasonably occur?

Figuring Out Your Cash Reserve Plan

Over the last 50 years, there have been 9 recessions.  The average length of these recessions has been 13 months.  That seems as reasonable a place to start as any.  If I wanted to be super conservative, the 2008-09 recession was 18 months long.

Now for the tough one, how deep of a cut to plan for.   A study published by the New York Federal Reserve proved very helpful for this.  The topic of the study was “Why Small Business Were Hit Harder” in the recession of 2008-2009.  A graph on page 6 revealed that during the height of the event, small business revenues were down about 20% from pre-recession levels.  It wasn’t 20% for the entire recession, it was more like a U shape.  I figured planning for 65% of the event at a 10% loss and 35% at a 20% loss seemed like a good, middle of the road estimate.  A deeper estimate might be a reversal of those percentages.

The Cash Reserve Calculation

Now we have our plan, let’s put it into action and see what happens.  Let’s assume the business has the following characteristics:

  • Revenue: $500,000 per month
  • Gross Profit $150,000 per month
  • Labor and Expenses $80,000 per month
  • Debt Service Payments: $20,000 per month
  • Cash Created Each Month:  $50,000 per month

The cash flow statement can help you figure this out quickly. Use it to understand how much cash your company creates each month, on average.

Now let’s apply the math:

  • A 20% reduction in revenue cuts $100,000 per month of revenue.
  • A 10% reduction in revenue cuts $50,000 per month of revenue.

If we are creating $50,000 each month in cash, then we are cash flow positive up to the point of losing 10% of revenue.  Under the middle of the road scenario, we will have 8 months of 10% sales loss, and 5 months of 20% business loss.  During the 20% loss, assuming margins and expenses are flat, we will lose $50,000 per month in cash for those 5 months.  To cover this period, we would need $250,000 in the cash reserve to cover the downturn.

Our doomsday scenario, an 18 month recession with 65% of the time period having a 20% loss would yield 12 months of $50,000 negative cash flow, would require a cash reserve of $600,000 to weather the storm.

There are a lot of moving parts in the P&L, so you may want to add some assumptions about margin pressure, supplier costs, interest rates, etc.

What if the Cash Reserve Is Not Big Enough?

What happens if you can’t build a big enough reserve?  If reality is not aligned with the plan, then what?  The next steps involve things like:

  • Bridge Financing
  • Expense reduction
  • Asset Sales/Reductions

The best thing to do is run the numbers a few different ways.  Estimate how big of a gap you are facing.  Let’s assume we are in the worst case scenario, and we need $600,000 to ride the storm out.  Cash reserves are $300,000, so we are $300,000 short.

We have $250,000 of monthly Cost of Goods sold, and the inventory is turning 3 times, so there is $1,000,000 of inventory on the books.  If we develop a plan to carefully reduce the inventory by 15%, we can produce about $150,000 in cash by not re-buying goods that we sold.  Moving the inventory from 3 turns to 4 turns would be a 25% inventory reduction, creating $250,000 in cash.  If you can reduce inventory without disrupting customer service, covering that gap might not be so daunting.

If we are lucky, and the inventory reduction went reasonably well, let’s assume we covered $200,000 of the $300,000 cash reserve gap.  We have $100,000 to go over a 12 month period, or around $8,500 per month during the worst of the revenue loss.  To cover this gap, consider things like selling unneeded assets, renting some warehouse or office space to a 3rd party, asset based financing, or other non-critical expense reductions.  I don’t specifically call out layoffs and benefit cuts as a strategy. That only tends to make a bad situation worse, putting your team on edge and eroding company culture.  If used at all, it needs to be a last resort.

The Bottom Line on Cash Reserve

Whatever you do, have a plan.  Think about your options before you end up in the crisis.  It is a very good idea to know what the trigger points are that will cause you to act.   “If revenue falls by X, then we will do Y”.  Be able to answer that question so there is no hesitation in the heat of the moment.  You have a plan, just execute to the plan.

Remember, cash is king, your goal is to not have sustained negative cash flow.  This will allow you to stay in the game and keep taking care of your customers and your team.

In short, estimate how much revenue and/or gross profit you may lose, then estimate the length of the event. After that apply these factors to your company’s current cash flow position.  This will tell you what the gap is.  Once you know the gap, start building your cash reserve to meet it.  Finally, develop a contingency plan to create additional cash in the event you come up short on your cash reserve.

The Atlas team can help you talk through these scenarios and plan for the future.  Reach out to us if you need us, we are happy to be of help to your company.