Growth companies eat cash, so the amount of cash you need depends on 1) how much you are spending ahead of revenue, and 2) how long it takes you to convert sales to cash. For example, if you hire a developer to create a new product, but you won't be able to sell it for a year, you'll need a lot of excess cash to help you finance that person's salary. And if you have 90 day payment terms with your customers, you'll need at least 90 days of operating expenses in cash while you wait for your sales to turn into a check you can put in the bank.
At Blue Fish, I keep all the profits in the company during the year, and at the end of the year, I do some forecasting to see how much (if any) of the excess cash can be taken out of the company. I do this by trying to predict the first quarter's expense needs and keeping at least that much cash on hand.
When forecasting cash flow and looking at how much money to keep in the bank, we look at more than just cash. We also look at our accounts receivable (A/R), accrued revenue not yet invoiced, and our sales pipeline.
Our clients are very large companies who almost always pay their bills, so we treat A/R as pretty much a sure thing. We add the A/R to our cash in the bank, and that's the number we are trying to make sure can cover 3 months of expenses. There's a risk that a client will pay late and leave us in a cash pinch, but we have a line of credit that we can draw on if we need to in that case. Other companies have a certain % of their customers default on their invoices, so you'll want to take that into account.
To predict expenses, we take the average of the past three months' non-salary expenses and add it to the previous full month's salary expenses. For us, salaries are by far the largest component of our expenses, and I use the latest figures since we may have just hired someone and I need to include their salary in my planning. I also factor in whether I am thinking of hiring someone in the future. I look at accrued taxes I'll have to pay, any known upcoming large expenses (like an office move), and any accrued bonuses or profit sharing that we might owe to our employees.
When doing cash planning, I don't try to predict what sales might happen or anything like that. But I use the sales pipeline to give me a sense of whether we'll have plenty of business, so I can be looser with cash, or if sales have been down maybe I should be tighter with cash. In 2007, we had our most profitable year to date, but we were scared about the economy, so we left a lot of that profit in the bank. That helped us weather a horrible 2008. If we had only left 3 months' expenses, I don't think we would have made it.
