Properly managing cash flow and working capital is essential for the success of any business. It may be especially important for small businesses that lack the financial resources that larger companies possess and that are typically more vulnerable to financial problems. While common sense may tell you that it’s best to have as large a cash reserve as possible, maintaining excess cash on hand may actually be detrimental to your business. There are potential disadvantages to keeping a large amount of your small business’s assets in the form of cash. Try to strike the proper balance between maintaining necessary cash reserves and hoarding too much cash.
Maintaining an Adequate Cash Reserve
Just as it’s important for individuals to have some emergency cash available to handle unexpected expenses, it’s also important for businesses to maintain enough cash reserves to handle things such as a temporary downturn in revenues or slow-paying customers. Many business experts recommend keeping three to six months of operating expenses in the form of cash on hand or assets that can quickly be converted to cash. The amount of cash reserve your business needs to maintain will depend at least partially on the nature of your particular business. is your business seasonal and therefore subject to long periods with little income? How vulnerable is your business to a general economic downturn? Considering such questions can give you a better idea of whether you need to keep a relatively smaller or larger cash reserve.
Dangers of Holding Excess Cash
One of the most significant potential disadvantages to holding excess cash can be the opportunity cost of hoarding cash. Holding cash is generally a disadvantage because inflation erodes the purchasing power of that cash. Cash held in a business checking account or even in the form of certificates of deposit or short-term bonds rarely pays sufficient interest to overcome the loss of purchasing power from inflation. However, the greater opportunity cost is usually the loss of additional revenues that could be generated from investing cash on hand in growing your business. It’s a bad financial trade-off to have cash parked in a checking account earning only 1 to 2% interest if that same cash invested in expanding your business could generate a return of 25% or more. Holding excess cash can also lead to a tendency to become careless with expenses. Holding a large cash reserve can result in a feeling of financial overconfidence that could cause you to commit cash to projects without adequate market research beforehand if you had a tighter cash flow, you might have determined that such projects would be unwise. It’s simple human nature that the more money people have, the less care they tend to exercise in managing it and the more extravagant they tend to be with expenses. Manage your cash flow by having a clear idea of your current expenses and potential near-term unexpected expenses, and maintain a good feel for the current and likely future condition of your marketplace. While keeping some cash in reserve is important, it’s also important for the growth and continued success of your business to put available capital to work in generating additional business revenue.