The question, “How much should I keep in the bank” comes up a lot when meeting with businesses across the spectrum. The answer I usually give is to keep in savings, or cash on hand, a minimum of two months of Burn (outgoing operating cash).
“How much cash should I keep in Savings?” = (COGS + Operating Expenses + Shareholder Draws) x 2
The Burn includes the following:
- Cost of Goods Sold (COGS): The reason I include COGS when figuring out a burn rate is that companies fail when they don’t have enough cash on hand to purchase the items or services they resell.
- Operating Expenses: This includes payroll, insurance, rent, essentially everything that is listed under “Expenses” when looking at a Profit & Loss Statement or Income Statement.
- Shareholder Draws: Owner Draws are not expenses to the company but they need to be factored in when calculating Burn Rate. You need to be able to feed yourself and your family.
Some important adjustments to the formula:
- Seasonal Companies: If a company experiences seasonal swings in revenue and expenses then a good conservative approach would be to calculate the burn rate during your busy season and not an average of the full year.
- Life Phases of Companies: If the company is in a growth phase that often means that you’ll be spending more now in the hopes of future payoff. For example, you hire more employees now knowing that it’s going to take them some time to get up to speed and start generating revenue then you need to factor that in to your burn rate. This simply means that you may need to run the above formula two or so times a year to evaluate your burn rate and ensure enough savings are available.
- Purchasing Assets / Investments: You may have a company that is dependent on certain assets to operate. Assets depreciate over time, break down, need repair or replacement. It’s always better if you don’t have to go into debt to replace an asset. Therefore, building up additional savings to factor in capital replacement costs is wise. This will vary by company.