How Much Cash Should a Growing Business Maintain?

A building materials distributor grows 30 percent in a year, earns a 6 percent net margin, and finishes with less cash in the bank than it started with. The owner reads the income statement, reads the bank balance, and asks the accountant where the profit went. The profit went to the warehouse and to the receivables aging. It is real, it is on the balance sheet, and it will not make payroll on Friday.

This article gives you a method for deciding how much cash a growing company should hold. It starts with the simple rule, months of operating expense, then adds the two things that rule ignores: the cash conversion cycle and the rate of growth. It closes with a target formula, a worked example, and a test for whether your line of credit is doing the job it was set up for. Every figure is illustrative. Your own numbers come from your own books, and the method is the point.

Months of operating expense: the starting point

The common rule is to hold enough cash to cover a set number of months of operating expense. The first task is to define the expense correctly: it is the monthly cash you must pay whether or not revenue arrives, which means payroll and burden, rent, insurance, debt service, software, utilities, and the owner's draw, not the GAAP expense line that includes depreciation and excludes principal payments. For an illustrative company with $650,000 of fixed monthly cash cost, two months of cover is $1.3 million.

How many months depends on how much can go wrong at once. A company with one customer above 20 percent of revenue, a seasonal trough, collection periods longer than 45 days, thin margins, or a bank covenant tested quarterly should hold more. A company with diversified customers, monthly billing, and a line of credit that actually rests at zero once a year can hold less. Two to three months is a reasonable starting range for most privately held companies in this size band, and it is a starting range, not a finding.

The rule's weakness is that it is static. It describes the cash you need if the business stops. It says nothing about the cash you need if the business grows, which is the situation most owners reading this are in.

The cash conversion cycle

The cash conversion cycle measures how many days a dollar is tied up between paying for something and collecting for it. It is days sales outstanding plus days inventory outstanding minus days payables outstanding. For the illustrative distributor: customers pay in 52 days on average, inventory sits 40 days before it sells, and vendors are paid in 30 days. The cycle is 52 plus 40 minus 30, or 62 days. Every dollar of daily revenue requires 62 days of working capital to support it.

A service contractor with no inventory and 35-day collections has a cycle of five days if it pays vendors in 30. A general contractor with retainage and 75-day collections can have a cycle over 60 days even with no inventory at all. A retailer that collects at the register has a negative cycle and gets paid before it pays. The cycle explains why two companies with identical revenue and margin can have completely different cash positions, and why the one with the longer cycle is always the one asking where the profit went.

Why growth consumes cash

When revenue grows, the working capital that supports it has to grow first. The arithmetic is direct: the additional working capital required is roughly the revenue increase multiplied by the cash conversion cycle divided by 365. For the illustrative distributor growing from $12 million to $15.6 million, the increase is $3.6 million. At a 62-day cycle, that requires about $612,000 of new working capital, funded in advance, before the new revenue produces a dollar of profit.

Then add the other uses of cash that growth brings: equipment and vehicles, tax distributions on the higher profit, and debt principal that the income statement does not show. The table below lays out the year for the illustrative company. It is profitable in every line of the income statement and shorter of cash at the end of the year than at the start.

Nothing in this table is a mistake. The company priced correctly, collected reasonably, and bought equipment it needed. It simply did not plan for the fact that growth is a use of cash, and it found out at the end of the year instead of at the start. A company that ran this table in January would have arranged the line of credit, slowed the distributions, or termed out the trucks before the shortage arrived.

Line of credit: buffer or crutch

A working capital line of credit exists to bridge the cash conversion cycle. Draws should follow the seasonal or growth-driven build in receivables and inventory, and repayments should follow collections. A line used this way rests at or near zero at least once a year, and the bank sees a balance that rises and falls with the business. That is a buffer, and it is the cheapest way to fund the $612,000 in the table above.

A line becomes a crutch when the balance never rests, grows a little every year, and starts funding things a line was never meant to fund: equipment, distributions, losses on a bad job, or the payroll in a month when collections came in late again. The test is simple. If the bank called the line tomorrow, could you make payroll next month? If not, the line is not a buffer. It is permanent capital wearing a revolving label, and the bank will notice before you do, usually at renewal.

The bank's favorite customer is the one who asks for the line in a good year and uses it in a bad one. Most owners do it the other way around. Arrange the line, or the increase, when the financials are strong and the request is easy to approve. Then run the business so that the line is available when the cycle stretches, rather than already fully drawn when it does.

A target formula

Combine the three ideas into one target. Start with fixed monthly cash cost multiplied by the months of cover you have chosen. Add the working capital that planned growth will consume, which is the revenue increase multiplied by the cash conversion cycle divided by 365. Add any lumpy obligations due in the next 90 days that the monthly figure does not capture: an insurance renewal, a tax payment, a bonus pool, a balloon payment. Subtract a haircut share of the line of credit availability you can actually count on, since a line is a substitute for some cash but not all of it.

For the illustrative distributor: fixed monthly cash cost of $650,000 at two months of cover is $1.3 million. Growth working capital is $612,000. Lumpy obligations in the next quarter are $180,000. The line has $1 million of undrawn availability, and the company counts half of it, or $500,000. The target cash balance is $1.3 million plus $612,000 plus $180,000 minus $500,000, which is about $1.59 million. That is the number the owner should see at the low point of the cycle, not the high point, and it should be compared with the actual balance every week.

The target is a floor at the low point of the cycle. Holding it at the high point and running below it for four months is not holding it.

Managing to the target

A target without a forecast is a wish. The 13-week cash forecast is the instrument that shows whether the balance will hold: weekly receipts by customer, disbursements by category, and the projected balance against the target for each of the next 13 weeks. When the projected balance drops below target in week nine, there are eight weeks to act, and the actions are known. Collections calls, a draw on the line, a delayed equipment purchase, a smaller distribution, or a conversation with the bank while the numbers still look good.

• Shorten the cycle before you fund it. Every day off DSO on $15.6 million of revenue frees about $43,000 of cash permanently. Invoice on the day of delivery, take deposits on large orders, and assign one person to call on day 31.
• Turn inventory faster. A distributor that moves days inventory outstanding from 40 to 32 frees eight days of cost of sales, which is more than the two trucks cost.
• Use vendor terms fully but not late. Paying in 30 days when terms are 30 is the cycle working for you. Paying in 45 when terms are 30 is a supplier problem you have not been told about yet.
• Term out equipment. Trucks bought with operating cash or the line consume the reserve. The same trucks on a five-year note match the cost to the asset's life.
• Set a distribution policy tied to the target. Distributions come out after the target is met at the low point, not before.
• Size the line for the cycle, not for the crisis. The line should be large enough to fund the seasonal and growth build in receivables and inventory with room to spare, and small enough that resting it at zero is realistic.

Where a fractional CFO fits

Most growing companies between $3 million and $50 million have a bookkeeper who records cash and an owner who watches the bank balance. Neither of them is computing the cash conversion cycle, projecting the working capital that next year's growth will consume, or telling the bank in March what the line needs to look like in September. A fractional CFO builds the 13-week cash forecast and runs it every Monday, sets the target cash balance from the formula above and refreshes it as growth plans change, manages the line of credit so it rests and renews, and turns the sources and uses table into the year's cash plan before the year starts.

The result is a company that grows on purpose: the owner knows how much growth the balance sheet can fund, how much the bank will fund, and how much has to wait. That knowledge is the difference between a profitable year that ends with a cash problem and a profitable year that ends with a larger company and the same night's sleep.