Whether it’s for your business or for yourself and your family, the first step towards reaping the hidden blessings of holding cash is to determine how much cash/liquidity you should hold at any time.
Ray Dalio, Founder of Bridgewater Associates said that “Cash is trash” and urges everyone to get out of cash in his speech at the World Economic Forum. A couple of months later, the US equity market begins to decline drastically as the economy heads to economic downturn due to the Covid-19 pandemic.
Most businesses witness drastic shutdowns and loss of revenues but continue to incur operational costs. Individuals see loss of jobs, pay cuts and loss of asset values.
Investors who have access to cash are able to take advantage of the attractive buying opportunities that the market decline presents. Businesses that have strong liquidity continue to operate remotely, keeping their staff whole while still meeting up with their operational costs. Individuals who have access to cash reserves continue to meet their expenses without liquidating their non-liquid assets or taking on new debts.
Determining How Much Cash/Liquidity You Should Hold
In my last article here, I talked about why cash is king and discussed the hidden blessings of holding cash. So, I got a question about how much cash/liquidity a business or an individual should maintain at anytime.
There is no magic number to this, but you can easily determine your cash needs based on the specific situations unique to you or your business. So, there are different elements that you need to build in to determine how much cash/liquidity you need to hold.
Average Monthly Expenses
How much do you typically spend in a month? For your business, take a look at your expenses each month for the past 12 months and get the average. It is important to use average monthly expenses because it builds in any seasonality that may be inherent in your business.
A Simple Example:
Assuming your business had the following monthly expenses in the past twelve months. Add all the monthly expenses and divide by 12 to get the average.
| Month | Expenses |
| January | 5000 |
| February | 5500 |
| March | 6000 |
| April | 4000 |
| May | 4500 |
| June | 7000 |
| July | 7500 |
| August | 7500 |
| September | 2000 |
| October | 2000 |
| November | 3000 |
| December | 3000 |
| Total Annual Expenses | 60000 |
| Average monthly expenses | 60000/12 = $5000 |
For you or your family, add all the expenses you typically incur every month. Focus on the must-pays. Do not include any wish-lists, we will get to that. Your must-pays should be about the same every month, so we will not worry about calculating averages.
Once you determine your average monthly expenses, you move on the next element, duration.
Duration
For how long do you need a financial cushion? How long should you be covered financially without any revenue or income?
Think of a scenario where your business receives very little or no revenues. How long you would need a cushion against any possible revenue loss? As an individual, how long would you need a financial cushion if you are to lose your job? How long will it likely take you to get another job? Or, if you are to have any medical situation that takes you out of the workforce without pay, how long would you need to be financially cushioned?
The commonly recommended duration is 3-6 months. To be play on the safe side, some people keep a duration of 12 months. There is a strategy to make this worthwhile if you plan to go beyond a 3-month duration. We will get to this strategy in a bit.
Run Rate
This is your basic liquidity needs. Determine what your basic liquidity needs should be using the average monthly expenses and the duration.
Example:
Average monthly expenses = $5,000
Duration = 6 months
Basic liquidity needs = $5,000 x 6
= $30,000
You can stop here if you are financially constrained or just want to meet your basic expenses. However, it is recommended that you always build in some cash reserves to enable you take advantage of opportunities and for contingencies.
Opportunities
Businesses and individuals thrive through opportunities. It could be opportunities for investments, a contract opportunity that may require immediate cash payment, or even a training you have been waiting on.
You need to set aside some cash reserves for such opportunities and add this to your cash needs for your chosen duration. Now, how much this would be will depend on how much you have already budgeted for opportunities.
Just like businesses, you should have your individual budget that outlines how you plan to spend your money. If you do not already have a budget, you can just estimate any amount you feel comfortable setting aside for your opportunities. This is totally up to you.
Once you have this number, add it to your basic cash needs.
Example: if you decide to set aside $5000 for opportunities, then your cash/liquidity needs will update as follows:
Basic liquidity needs = $30,000
Opportunities = $5000
Liquidity needs for 6 months = $35,000
But we are not done yet. You need cushion for emergencies, and that takes us to the last element.
Contingencies
Set aside some money to take care of emergencies and any other expenses you may have missed in your basic liquidity needs. These contingencies are usually unplanned, so you build in whatever amount you are comfortable with based on your financial goals.
Example: If you decide to set aside $6000 for contingencies, your total cash needs will update as follows:
Basic liquidity needs = $30,000
Opportunities = $5000
Contingencies = $6000
Total Cash/Liquidity needs for 6 months = $41,000
Strategies for Holding Cash Beyond a 3-Month Duration
Now that you know your duration and how much cash you should hold, let’s take a look at how to maximize your liquid assets so that you take advantage all potential returns on your cash and at the same time, reap all the benefits of holding cash.
If you have a duration of 3 months, then you do not need to do anything further; just hold your total cash needs in a checking or savings account. I recommend, however, that you keeping a separate account different from the one you regularly use. The key is to have limited access to this fund and only access it when the need arises.
However, if you have a duration of anything beyond 3 months, say 6 months as in our example, then break up your total cash needs into two groups:
Cash Needs for the First 3 months
This group will include:
Basic cash needs for the first 3 months = $5000 X 3 = $15000
Opportunities = 5000
Contingencies = 6000
Total for the first 3 months = $26,000
You will hold this amount ($26,000) in your regular checking or savings account that you have limited access to, so that when the need comes, you can easily access it.
Remember, the strategy here is to keep in your checking or savings account, only your basic cash needs for the first 3 months, reserve for your opportunities and contingencies.
You will then hold your reserve for the rest of the months as described below.
Cash Needs Beyond 3 months
This group will include only your basic cash needs beyond 3 months.
From our example above (duration of 6 months), the basic cash needs beyond 3 months is just for the remaining three (3) months as follows:
Basic cash needs for the remaining 3 months = $5000 X 3 = $15000
Total cash needs beyond 3 months = $15,000
You will hold this amount ($15,000) in any 3-month short term investment such as a 3-month treasury bill, certificate of deposits, or fixed deposit.
The strategy here is that while you have your basic cash needs and the reserve for opportunities and contingencies in an account you can easily access (which pays little or nothing in interest), you will also be earning some returns on the cash reserves you are holding beyond 3 months through these short term investments.
So, out of your total cash needs of $41,000, you will keep only $26,000 in checking or savings account, then put the remaining $15,000 in short term investments as explained above.
I hope you find this useful for yourself or your business. Do you need help getting your finances together, let me work with you! Schedule a session with me here.
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