It is an enviable position. The business has been managed well over time. Cash has grown and you now have the enviable position of trying to figure out the highest and best use of the funds. The first question to ask is: “What is the right amount of cash to manage the business?”
In this article, I’ll outline five topics that should be considered in deciding how much cash is appropriate in the business, before decisions are made on how best to deploy the funds:
What are the long-term plans for the business? – Long-term perspectives vary widely across businesses. Some businesses are content with their current footprint, market share and competitive position. Others look to grow quickly through acquisition or organic growth. The level of funding needs can vary significantly based on the long-term growth plan. Staying in a current footprint may require no capital for growth, while acquisitions may require some cash and some debt based on the desired leverage. Knowing your plan is important to understanding the capital needs.
How much capital is needed to support the current business? – Some businesses have very little capital expenditure needs, while other businesses require significant capital. Assets have lifespans that vary based on the amount of maintenance over time. At some point, the assets will need to replaced. Understanding the amount of capital necessary for maintaining and replacing assets is a critical component of understanding the capital needs of the business. A robust capital plan will indicate how much cash is needed and when to support the business.
How much of the business cost is fixed vs. variable? – Many businesses cycle up and down based on the economy. The real fixed costs in the business do not go away when the economy contracts. These are contractually obligated costs such as building leases, debt service, union contracts, etc. You have to pay the costs until the contract runs out, or for a period of time once you trigger an exit option. The trick here is to know how the business can flex up and down, how much the fixed costs are and how long the business may have to operate with minimal revenues in a worst case scenario. This look gives you a perspective on your liquidity needs – whether cash on hand or credit lines available. Do you have enough cash to make it through this period of time?
Where are the best returns? – Typically the highest expectation of returns is with equity. That is because it is the highest risk capital in the business – equity owners only see returns after all other debt is serviced. As a result, given the higher risk profile, the expectations are typically higher around return on equity. If cash is sitting on the sidelines beyond what is needed by the business, there are other opportunities for it to be deployed. Many times, the capital structure of the company is evaluated for the right balance of debt and equity. This is typically the point where a decision is made to distribute cash to owners if the funds internally are not generating a return above the expectations for equity in the business.
What is the tax structure of the business? – Depending upon the legal structure, the owners may be consolidating the results of the business into their personal tax returns or the company may be paying the taxes and the owners only see a tax impact when dividends are made. Taxes vary widely based on the situation of the owners, the state, the corporate structure, etc. Understanding where cash sits and what happens if distributions are made is an important consideration in where cash resides.
In addition to the above, understanding the risk tolerance is important to determining how much cushion is needed above and beyond the specifically outlined needs. Having a strong perspective on the capital and liquidity needs of the business is a prerequisite to determining the best options for investing and deploying excess cash. How are you determining how much cash you should have on hand?
Copyright © Heidi Pozzo.
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Heidi Pozzo is a strategy and performance improvement consultant. She has helped transform businesses by connecting the people in the company to the strategy, resulting in significant increases in earnings and business value. To find out more about her services,
or call 360-355-7862.