In today’s uncertain marketplace, many businesses are stashing operating cash in their bank accounts, even though they might not have imminent plans to deploy their reserves. However, excessive “rainy day” funds could be an inefficient use of capital. Here’s a systematic approach to help estimate reasonable cash reserves and maximize your company’s return on long-term financial positions.
What’s the harm in stockpiling cash?
An extra cushion helps your business weather downturns or fund unexpected repairs and maintenance. But cash has a carrying cost — the difference between the return companies earn on their cash and the price they pay to obtain cash.
For instance, checking accounts often earn no (or very little) interest, and many savings accounts generate returns below 2%. If a company has cash reserves while simultaneously carrying debt on its balance sheet, such as equipment loans, mortgages and credit lines, it will pay higher interest rates on loans than it’s earning from the bank accounts. This spread represents the carrying cost of cash.
What’s the optimal amount of cash to keep in reserve?
Unfortunately, there’s no magic current ratio (current assets divided by current liabilities) or percentage of assets that’s right for every business. A lender’s liquidity covenants are just an educated guess about what’s reasonable.
However, you can analyze how your company’s liquidity metrics have changed over time and how they compare to industry benchmarks. Substantial increases in liquidity — or ratios well above industry norms — may signal an inefficient deployment of capital.
Prospective financial reports for the next 12 to 18 months can be developed to evaluate whether your company’s cash reserves are too high. For example, a monthly forecasted balance sheet might estimate expected seasonal ebbs and flows in the cash cycle. Or a projection of the worst-case scenario, based on certain what-if assumptions, might be used to establish a company’s optimal cash balance. Forecasts and projections should take into account a business’s future cash flows, including capital expenditures, debt maturities and working capital requirements.
Formal financial forecasts and projections provide a method for building up healthy cash reserves. This is much better than relying on gut instinct. You also should compare actual performance to your forecasts and projections — and adjust them, if necessary.
What’s the highest and best use of excess cash?
After prospective financial reports and industry benchmarks have been used to determine a company’s optimal cash balance, management needs to find ways to reinvest its cash surplus. For example, you might consider repurposing the surplus to:
- Invest in marketable securities, such as mutual funds or diversified stock-and-bond portfolios,
- Repay debt to lower the carrying cost of cash reserves,
- Repurchase stock, especially when minority shareholders routinely challenge management’s decisions, or
- Acquire a struggling competitor or its assets.
With proper due diligence, these strategies could allow your business to reap a higher return over the long run than leaving funds in a checking or savings account.
We can help
Contact us for help creating formal financial forecasts and projections and evaluating benchmarking data to devise sound cash management strategies. We can guide you toward more efficient use of capital, while reserving enough cash on hand to meet your business’s short-term operating needs.
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FAQs
If a company has cash reserves while simultaneously carrying debt on its balance sheet, such as equipment loans, mortgages and credit lines, it will pay higher interest rates on loans than it's earning from the bank accounts. This spread represents the carrying cost of cash.
Why is it bad for a company to have too much cash? ›
More often than not, a cash-rich company runs the risk of being careless. The company may fall prey to sloppy habits, including inadequate control of spending and an unwillingness to continually prune growing expenses. Large cash holdings also remove some of the pressure on management to perform.
Is it bad to have too much liquidity? ›
It can also be a hurdle for business expansion. Excess liquidity suggests to investors, shareholders, and analysts that the firm is unable to effectively utilise the available cash resources or identify investment opportunities that can generate revenues.
What is the problem with too much cash? ›
Cons: The cost of holding cash
Inflation risk: While cash has no capital risk, inflation can erode its purchasing power – meaning you wouldn't be able to buy as much with it in the future.
What are the disadvantages of keeping large amounts of cash in a business? ›
Excess cash has three negative impacts:
- It lowers your return on assets.
- It increases your cost of capital.
- It increases business risk and destroys value while making the management overconfident.
Though the term is meant to be humorous, there seems to be truth to it. Studies have actually found that wealth may be at odds with empathy and compassion. Gamble agreed, arguing that having “too much money” can lead to acting more selfishly or recklessly.
What are the problems associated with holding too much cash? ›
However, holding too much cash can have negative consequences, such as reducing returns, increasing opportunity costs, and exposing the organization to inflation and currency risks.
Is it bad to have a lot of cash? ›
However, holding too much cash beyond emergency funds or short-term needs may be dangerous. At the highest level, it could lead to significantly less wealth over time. Since 1928, U.S. Stocks have outperformed cash in 68% of the calendar years.
What are the negative effects of liquidity? ›
Another part of researchers noticed the negative effects of liquidity on profitability mentioning disadvantages of holding current assets in comparison with fixed assets, known as less profitable as keeping liquidity can result in accumulation of idle assets and inefficiency of financial management.
Why might too much liquidity be a problem for an organization? ›
In today's uncertain marketplace, many businesses are stashing operating cash in their bank accounts, even though they might not have imminent plans to deploy their reserves. However, excessive “rainy day” funds could be an inefficient use of capital.
Carrying large amounts of cash is not an illegal act in and of itself. Despite the popular misconception, under U.S. law, there is no legal penalty for holding any sum of cash in any U.S. jurisdiction.
What happens when too much money is made? ›
Because consumers have more money, they pay higher prices and feed inflation. If economic output continues to stagnate or shrink and inflation keeps rising, companies charge more, consumers pay more, and the central bank prints more money. A cycle of increasing inflation rates occurs, leading to hyperinflation.
Why is cash a problem? ›
Cash can be used in criminal activities such as money laundering and tax evasion because it is difficult to trace. Digital transactions or electronic money create an audit trail for law enforcement and financial institutions and can aid governments in economic policymaking.
Why is it bad for a business to have too much cash? ›
The worst-case scenario is that excess cash can affect the trading status of your business, turning it from a trading company to an investment company, which can result in Business Relief being denied. It could also reduce the value of the company that would qualify from BR by the value of the 'excepted asset'.
What are the disadvantages of cash payment for business? ›
Cash doesn't protect your customers and your business.
If they trust their transactions, customers are more willing to spend money. Cash doesn't provide that comfort. Additionally, unscrupulous employees may be tempted to steal from your cash register or pocket some cash transactions.
What is one impact of a business having limited cash? ›
1) Inability to pay suppliers
If you can't pay your suppliers, this can lead to poor business relationships and damage to your reputation. It may also impact your ability to meet your own deadlines and contractual obligations.
What does it mean when a company has a lot of cash? ›
A cash flow positive company typically indicates a healthy financial position, as it signifies that the company has a surplus of cash available to meet its financial obligations and fund future growth. This positive cash flow can be used for various purposes, such a.
Is it good for a company to have a lot of cash? ›
Fun fact: it's not always better to have a lot of cash on hand. Big cash reserves don't actively contribute to business growth and leaving money lying stagnant may cause you to miss out on growth opportunities. Plus, investors like to see growing balance sheets, not flat lines.
Why is it illegal to have too much cash? ›
Having large amounts of cash is not illegal, but it can easily lead to trouble. Law enforcement officers can seize the cash and try to keep it by filing a forfeiture action, claiming that the cash is proceeds of illegal activity. And criminal charges for the federal crime of “structuring” are becoming more common.
What are the disadvantages of surplus cash? ›
Surplus cash can have three negative consequences:
It can reduce your return on assets. Surplus cash that isn't needed for business operations is unproductive. This cash could instead be invested in income-generating projects. It can elevate your cost of capital.
