Saving vs. spending: What's the right balance for your business?

Running a successful business requires investing in improvements while maintaining a healthy amount of liquidity. This approach enables you to stay competitive and manage day-to-day expenses.

The right mix of saving and spending depends on your business goals and circumstances. As your priorities change, the optimal mix might as well.

Jim Cohill, Director of Business Banking for New England South at Citizens, discusses five key questions that can help you strike the right balance.

1. What is your balance now?

The warning signs of having too little liquidity — difficulty making payments on time, having to postpone needed purchases — are fairly easy to recognize. Gauging whether you’re holding too much cash can be more difficult. Talking with a business banker who will review your business finances and your upcoming plans can give you valuable insight.

“Not being able to meet your expenses could be catastrophic, but so could not investing enough,” Cohill says. “The other thing to watch out for is whether you’re getting the most value from the cash you have — for example, by keeping it in a money market account or longer-term savings vehicle where it could earn interest.” Talking with a business banker can help you uncover possibilities that strengthen your business and its financial position.

2. What do your numbers tell you?

Having a grasp of a few key figures can give you valuable insights into your financial health and whether opportunities may exist to free up cash. A few figures that Cohill recommends knowing include:

• Quick ratio. This measures a company’s ability to meet its short-term obligations with its most liquid assets. To compute it, divide your current assets minus inventory by your liabilities. This calculator can help.
• Inventory days on hand. This shows how efficiently a business frees up cash that’s tied up in inventory. Calculate this figure by dividing the average inventory for a certain period (reported on the balance sheet) by the corresponding cost of goods sold for the same period (reported on the income statement). Multiply the result by 365.
• Accounts receivable turnover ratio. This shows how effective a business is at collecting money that it’s owed. To calculate it, divide credit sales by the average accounts receivable value for the same period.

Talk with your accountant or business banker to understand what these numbers say about your approach to spending and saving. You can also see how they compare with other businesses in your industry by checking resources such as BizMiner, the Risk Management Association’s Annual Statement Studies, and Dun & Bradstreet’s Key Business Ratios.

3. What are your near-term plans?

There are certain situations in which liquidity is essential. If you’re planning to roll out a new product or service, for instance, having cash available for testing and marketing could be critical to its success. If you’re considering applying for financing, liquidity is also important, since lenders will want to see that your cash flow is strong.

“If you have funds tied up in growth investments, you may not have the liquidity that lenders are looking for,” Cohill says. Shoring up your liquidity position and cash flow before you apply may be required.

Good liquidity can offer other advantages as well, such as allowing you to capture discounts on bulk inventory purchases and extend terms for accounts receivable. “That could potentially allow you to collect more money than if you needed funds faster,” Cohill says.

4. How competitive is your business?

If you’re lagging behind other companies — in breadth of offerings, production volume, or another key area — some strategic investment may be necessary to regain ground. If your business feels stagnant, or operations aren’t as efficient as they could be, that may also indicate that spending is needed.

“Keeping up with developments in technology is important not only to operate efficiently and stay competitive, but to be able to adapt for the future,” Cohill says. If you’re considering selling your business, investments in technology or equipment may help to increase its value.

The caliber of your staff is also a competitive differentiator, and one that requires investment. “Especially now, given how tight the job market is, you might have to pay more to attract the right people,” says Cohill. “But that investment can pay back substantially over the long term.”

5. Could you manage the unexpected?

Even if you’re focused on growth, you need to have a cushion to accommodate unforeseen expenses. Equipment may falter, a key customer could leave, or collections may slow down. Though a rule of thumb is to set aside three to six months of operating expenses, that might not be realistic for all businesses.

“The right amount to have in a reserve fund will depend on your type of business, how long you’ve been established, and what your particular risks are,” says Cohill. You might make a list of events that could hurt your business if not quickly resolved, and then calculate how much to set aside by assigning a dollar value to these events and considering the likelihood that they will occur. For example, if a key piece of machinery would cost $8,000 to replace, and you think there is a 25 percent chance that it will need to be replaced this year, you might set aside $2,000 to help cover that cost.

No matter the size of your cash reserves, it’s important to keep them in a separate, easily accessible account, such as a money market. “Contribute to it as you can, and keep the funds untouched,” Cohill says.

The bottom line

These questions can provide a strong foundation for a conversation with your business banker or other financial advisor. Your answers may be the first step in building a financial plan that helps to balance liquidity with growth investments. To connect with a business banking professional, call 1-800-428-7463 or stop by your nearest Citizens branch.