Business is uncertain by its very nature. If it wasn't, everyone would be an entrepreneur. It's what makes business both exciting and stressful. However, good business leaders know the risks they take and make sure they have strategies in place to mitigate downside risks.
Having the right rainy day fund to help cover shortfalls can be the difference between making it through some hard times and finding your business on life support. However, squirreling away too much cash can mean anemic growth and missed opportunities.
As a business coach who works with CEOs in many different industries and in companies of different sizes, I've learned that calculating this number is a balancing act. Here are some of the factors that you need to consider when deciding how much to squirrel away for a rainy day.
Core staff payroll
For most businesses, people are the most critical and important asset. A company with a team of A-players will outperform the industry every time. Losing these people can be disastrous for the business. You need to make sure you can cover their salaries and benefits for however long you think it might take to get back on your feet.
Non-critical staff payroll
While some staff are no longer needed if your business takes a downturn, you may not be able to cut them quickly. Make sure you have enough to give them enough notice and runway to find another position. Another option here is to put them on furlough if you think business will come back in a reasonable timeframe. I've also had clients who negotiate a partial pay package or a deferred pay arrangement.
Fixed critical expenses
Some expenses can't be reduced or cut without serious deleterious effects on the business. This includes things like rent, insurance, utilities, etc. Make sure you have enough to cover these items and avoid a painful disruption to the business.
Variable and semi-variable expenses
Things like costs-of-goods-sold will directly lower in a downturn. Other costs, like attorney fees associated with new contracts, will also decrease with slower business. Look through your chart of accounts and identify those expense items that will get cut or lowered if sales and revenues fall unexpectedly. Taking action on these items quickly can give you more runway for critical expenses.
Another thing to factor into your calculation is your current accounts receivable. For invoices that have been delivered in full and there is no work remaining, you should be able to collect on that money. If you have invoices associated with partial delivery or need-to-complete future work, you might need to factor them to some level.
Your accounts payable will be a big factor in how much of a cushion you need. If your business hits a few bumps and you don't have new cash to make payments, you'll need to start prioritizing quickly. Focus on critical vendors and suppliers first. And try to negotiate payment terms and a schedule sooner rather than later.
Access to outside funds
If you have access to outside funds, you might not need as big of a cushion. This could be liquid or semi-liquid assets from the owners. You can also look to debt options; however, asking for debt when things are not going well can be a very difficult and expensive option.
Cost of re-hiring
One of the best calculations you can do is to figure out the break-even time between how much you save by letting someone go in a downturn and what it will cost you to replace them when things pick back up. Often times, it's cheaper to pay someone even if you don't need them for a few months than to later go through the pain and cost of recruiting and training someone new.
Sometimes I see clients that have too much tucked away. They've amassed large sums of cash out of worry for the next downturn. In the meantime, they've neglected to re-invest in their business to help it grow and prosper, and have missed key financial opportunities. Strike a balance between protecting against undesirable events and pursuing growth and scale.
Risk tolerance and stress
In the end, everyone has a unique risk profile. If keeping your emergency fund lean means you're on-edge and having sleepless nights, then put more away. Increasing your stress and anxiety will reduce your performance and hinder your ability to deal with the situation should a downturn show up.
The amount you should put away is a combination of rational logic and emotional security. However, don't just put money away and forget about it. As the business grows and evolves, so should your calculation and the balance in the account. Forgetting to do so can expose you to risks you didn't intend to take.