How much should I keep in the bank?

This question comes up a lot for small business owners and therefore for their accountants. And somehow, somewhere a figure of 3 month’s running costs has got established as a prudent rule of thumb for how much a business should have set aside. In this blog we explore this issue.

Sadly, or maybe gladly, there are few if any rules in business and while you could do worse than follow the 3 months running costs rule it misses far too much to be of real use.

The first thing to point out about it is that there is little purpose in keeping 3 months running costs in the bank if you are running up debts. Let us illustrate the point.

Which would you prefer?:

  • £30k in the bank with debts of £50k
  • £10k in the bank with debts of £5k

It also ignores customers who owe you money. Again, if you had to choose between the following which would you opt for?

  • £10k in the bank with £50k owed to you from sales on credit
  • £30k in the bank with £5k owed to you from sales on credit

In both cases just following your 3 month running cost rule of thumb might lead you to a false conclusion about the state of your cash flow. In fact accountants are trained that a much better measure of the health of a business in terms of cash is something called the Current Ratio. This is the ratio of Current Assets to Current Liabilities where Current Assets are defined as Money in Bank + Trade Creditors (people who owe you money) + Value of Stock and Current Liabilities are defined as anyone who you owe money to in less than a year (suppliers, HMRC, staff wages, loan repayments etc).

The idea here is that your Current Assets are things that you will soon become cash and Current Liabilities are things that will soon be liable to be paid. In our experience when Current Liabilities are greater than Current Assets cash feels very tight in a business and there is a danger of running out of cash. When the ratio goes above 1:1 things feel easier. By the time the ratio is 1.5:1 (ie Current Assets are 1.5 times Current Liabilities) cash is very healthy and above that figure we wonder why the cash is not being invested. If we are feeling more cautious we remove Stock from the calculation of Current Assets and this is called the Quick Ratio.

But even with these rules of thumb about the Current Ratio we run into a problems because the measure ignores that all good business people should be allocating their resources in order to maximise the return. Again this is probably best illustrated with some examples. So once again we can illustrate this with a choice:

  • £30k in the bank with nothing invested
  • £5k in the bank with £25k invested in something that is going to bring £80k in revenue next month

Rarely are the choices we make in business this extreme but it illustrates the point. That is not to say we should invest every last penny we have because in doing so we risk going out of business. We risk losing our return of our existing investment in the business because the other use of cash (aside from allowing investment) is that it keeps the business machine running. Staff get paid on time, suppliers don’t close their accounts with you, the wheels stay turning. So most of us would choose the second option out of the two scenarios below:

  • £30k in the bank having lost a customer that has up to now provided you with half your revenue
  • £15k in the bank with no real likelihood of losing revenue.

Our real point in all of this is that the decision about how much cash to keep in the business is a judgement and a judgement that is likely to change with the circumstances and change with your plans for development. The judgement needs to factor in the likely risks to the business and the investment opportunities we have. We are like the skipper of a sailing boat. We need to decide when to trim the sails and bring the boat close to the wind and when to let them out and fill them with the available breeze.

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