You’ve worked hard to build your company or startup. And you know that because you’ve got a nice fat cushion of cash sitting in your checking account, right?
Well no, it’s not working for you if it’s sitting there, so let’s get that cash productive again!
Business is a balancing act of cash in and cash out. How much cash your business needs to fund itself (given its ebbs and flows day-to-day and month-to-month) is called your working capital.
Yes, it is possible to have too much working capital—and it can hurt you down the line. Your job is to regularly get that capital moving out to where it can be productive. Here are four tips to that end.
Tip #1 – Identify Your Excess Cash
How do you calculate working capital? For simplicity, let’s talk about a creating a quick-and-dirty estimate using your bank account downloads or your accounting system, such as QuickBooks.
Here’s how. Look at your daily cash balance for the last six months and see where the low points are. Where did you have the least amount of cash (assuming you’re keeping up with accounting evenly)? It’s helpful to compare both the bank and the G/L here because the bank is on a real-time basis, not subject to accounting’s timing issues.
Let’s say you see, over the last six months, that the lowest cash balance you had was $150,000. I would argue that your low watermark balance can be a good indicator of your excess cash: $150K. Are you willing to take that money out of the business?
Depending on your company’s volatility or seasonality, consider at least moving a large percentage of that amount and leaving a smaller (and cheaper) cushion. (Of course, if your elevated cash was there for a specific or one-time purchase, that’s fine and a whole other topic. Back that out of your estimates here.)
To find your working capital requirements, look at your statements for your average high points of cash across the same time period. The delta between your min and max cash levels is roughly your working capital, and that low of $150K is your general excess from a conservative perspective.
Tip #2 – Excess Cash Makes for a Costly Insurance Policy
How much capital you need depends on many factors, including variations and timing of the ins and outs.
I explain this to business owners all the time and it’s important to understand. You’re willing to incur the opportunity cost of holding cash in your bank account as an insurance policy for things that could potentially go wrong.
And I get it: a supplier could disappear, or you might lose employees and have to quickly engage a recruiter. That’s unforeseen. Extra cash, however, is a costly insurance policy for the unforeseen.
You are giving up what it could be doing for you. And if you are growing, then small incremental changes early on can have huge benefits later. You need to keep moving.
Tip #3 – Swap Excess Cash with a Line of Credit
Instead of using excess cash as insurance, replace it with a strong line of credit that you can access in the case of an unforeseen or unplanned event. If something happens, or you want to take advantage of an opportunity (e.g., buy a piece of equipment), or fight proverbial fires, then you have this line of credit to fill in those gaps.
Building an ongoing relationship with your bank or a banker will go a long way, too. Longer than just one piece of equipment. In other articles, I’ve talked about the importance of this step: get a line of credit started ASAP if you don’t have one already.
Plain and simple, your insurance policy should be the line of credit, not cash.
Build that relationship over time. Get that credit line in place and use it well as you continue to grow in profitability. These steps will allow you to have a stronger banking relationship later down on the line when you need it.
Tip #4 – Think Ahead: Excess Cash Can Penalize You in a Sale
In a previous article, I shared a favorite quote: “Run your business like you’re going to own it forever and run your business like you’re going to sell it tomorrow.”
Yes, think ahead to the sale of your business. After talking to a dozen bankers about this, I want to emphasize that excess cash can hurt you when you sell your company.
Why is that? The buyer sees all that cash and assumes, “This must be the appropriate amount of working capital for this business.” When you paper out an M&A deal, you’re creating a working capital adjustment.
The buyer says, “We want you to leave enough cash in the business so that when we take over, we don’t have to infuse capital right after writing you a check.” They want it to have the cash to operate successfully, and they assume your averages are correct.
The business owner may say, “No, no, no, no. We only need $400,000 in working capital. I know there’s $600K in there, but I just haven’t taken it out.”
The damage may be done, however, especially if you’ve had it in there for three years, five years, or 10 years. It will appear to the buyer that you have it there for a reason, and they’ll want to keep it in as part of the sale. Thus, you may struggle to get your cash out in the sale negotiation.
When you’re running an excess position, you lose negotiation leverage as to your true working capital. I know it seems like math should figure it out, but in reality, buyers negotiate it. Investment bankers see business owners lose hundreds of thousands of dollars just on the working capital adjustment because they didn’t have their working capital dialed.
Obviously this fourth tip is thinking way ahead to a later stage, but it’s important because you are building your future history of cash management right now.
Certainly no one wants to lose 100 grand or even 10 grand in excess working capital! Even if you get a check for $3 million, you’ll know in the back of your mind if it could have been $3.1 million. Move that cash.
Make Your Cash Work for You
Managing your working capital is a process that pairs well with understanding your cash conversion cycles—because when you shrink your cash conversion cycles, the amount of working capital you need will decrease.
A full working capital analysis, as well as a good cash flow analysis, can help you to figure out what’s typically going out, coming in, and when can you can afford to expand.
We’re doing this with a company right now who has enough work to hire 30 more people this year, but isn’t sure when they can afford it in terms of their cash cycle. We figured out how they could push on collections and deploy that into hiring more people.
If you are running a cash-rich business, you have to ask yourself right now: how are you making that cash useful?