“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it” – Warren Buffett
All organisations need cash to live, breathe and operate on a daily basis. Cash is very much like oxygen, not really a big deal until you don’t have any and then it’s a really big deal, really quickly. Furthermore it doesn’t matter how healthy you are, if you’re without air for a short period, you’re in trouble.
Organisations are exactly the same. An organisation can be extremely prosperous for many years but become unstuck if they are left without the required cash to meet their commitments for even a short period of time. How long will employees be willing to work without pay? How long will suppliers continue to provide their services on credit?
It’s a scary thought, but cash flow risk can largely be mitigated by building a strong reserve. All shortfalls in cash must financed. They can be financed through financiers such as banks, your suppliers offering credit, or your own cash reserves/savings.
Cash reserves are the safest, easiest and most reliable safe guard against cash flow issues.
To state the obvious, cash is an asset that your organisation owns, an asset that you control and, most importantly, an asset that doesn’t need approval from a third party (such as a bank) to access.
So how much cash should your organisation put aside? This is a difficult question and will largely depend on management’s risk tolerance and the perceived risks that your organisation may face in the future. For example, risks such as your cash-flow cycle, income model (ie block funding in advance or individualised payments in arrears) and competitor landscape should all be considered when evaluating risk. Understanding the kind of financial or cash flow risks you are facing will help you to identify the level of reserve needed to protect your organisation.
An organisation with management that are not overly risk averse and not overly concerned about any perceived future risk, may not believe that they need large cash reserves. Conversely an organisation that is worried about the future risk they may face, may choose to build large cash reserves.
As a general rule at least three months of all expenses should held in cash in reserve. Ideally six months will be held, and 12 months plus is, of course, a much more conservative approach. When evaluating how much cash to hold in reserve it is also important to consider the timing associated with risks. For example if your organisation has a risk of losing funding but will be given a minimum of three months’ notice, then this should be factored in.
The rationale here is, if no income at all came in – not a single dollar – how long would you need to operate to get yourself back on track or at minimum payout all your obligations to staff and third parties? However if the likelihood of you losing all your income at once is low, you should reflect this when setting your reserves level.
As outlined above, a number of factors need to be considered and analysed. When considering these factors, an independent qualified adviser will be able to help you navigate your options relative to your risk exposure, and ensure that you calculate the appropriate amount of cash reserves for your organisation.
To find out how CBB can assist, please get in touch with Dimitri: