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In terms of public companies, if your cash balances are too high (effectively earning almost nothing), the shareholders will criticize management for not putting that excess cash to use, to grow the business. In the absence of investment opportunities, the shareholders will want the company to use the excess to pay dividends or to buy back stock. In the second case, assuming the market doesn't react negatively to the buy-back, each share of outstanding stock is worth more. because earnings haven't changed, but the number of outstanding shares has decreased.

Unfortunately, their is no single optimum cash balance, because the answer is dependent on so many variables, many of which may or may not apply to any particular business. For example, if you are a professional services firm, for example a law firm, you typically bill for your services after the services have been provided. Of course, the lawyers who did the work, have to get paid their salaries on a regular basis, in many cases, a long time before those billings (now accounts receivable) have been collected. So, if your outstanding receivables average 60 days, ideally, your minimum cash balance would be about two months of expenses. This is usually too high though, for several reasons. Some of your cash needs could be supplemented with a bank working capital line of credit, which fills in cash flow gaps, like the scenario I just mentioned.

Of course, your cash requirements may also be lower because you are still collecting receivables from one and two months ago.

The above is just an example. Really, the best way to approach this problem is to look at similar businesses in your industry (financial information on publicly held companies is always available through "Google Finance" and other sites). There are other services that provide information on privately-held companies, which is not available to the public, so these services can be pricey.

Start with the public companies - size doesn't matter, because you will be converting your statements and the public statements to what are referred to as "common-size" statements. You should be able to download balance sheets to an Excel spreadsheet, and choose as many periods as you can. Then convert each number in the financial statement to a percentage. Each asset is divided by total assets, and each liability is divided by total liabilities and equity. Total assets should be 100% and total liabilities and equity should total 100% Do the same with your own statements, using as many years as you can.

What you have just down is revised the balance sheets of the public companies to enable you to compare them to yours. Despite some outliers, you will most likely see a patter develop (example: companies in my industry tend to keep cash on hand equal to approximately 8% of total assets), a kind of rule of thumb that you can adopt and change as needed. Google finance can give you all the data for an entire industry segment, for which you can do the same things.

That's a great way to start. And one to build a cash projection around.

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14y ago

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