We recommend that every transportation company strive to have a 10-30% cash reserve. Why? Keep reading to find out.
First let’s cover what a cash reserve is. A cash reserve is a portion of your revenue set aside to navigate obstacles in your path to profitability or seize unforeseen opportunities. Maybe you will need to draw from your cash reserve to hire a new driver after an influx of business. Or, in the face of an economic downturn, your cash reserve can give you the funds needed to cover essential expenses like employee salaries. This could prevent you from having to get a business loan or draw on your line of credit.
We always recommend that you strive for a cash reserve between 10-30% of your annual revenue. Not all transportation companies will be there right away. This is more a goal to strive for rather than an absolute marker of “business safety”. Also, it’s not a matter of one or the other. You don’t need to choose between a 10% or a 30% cash reserve. 10-30% is actually a range that we use for quick math. The exact cash reserve you need to strive for can be calculated using a formula. We will give you that formula in the next section.
We also tell our clients that how much you set aside in a cash reserve will depend on how much risk you are willing to take. In other words, 10% equals roughly two months’ worth of expenses, while 30% covers about six months. If you want to play it safe, you can always aim to set aside 30% to give your company a little wiggle room in case of a catastrophe (or a once in a lifetime opportunity) comes your way.
How Do I Calculate My Ideal Cash Reserve?
To find out the ideal cash reserve for your transportation business, you will want to use the following formula.
Let’s start by dividing annual revenue by 365 – this gives you your average daily revenue. Then, subtract accounts payable days from accounts receivable days: The outcome represents your cash usage, the amount of time you need to have your bills (AP) covered before your cash comes back in the door (AR). Once you have calculated daily revenue and cash usage, you can multiply the two numbers. This is how much cash you should set aside in a reserve.
Keep in mind, if you tend to be more conservative with risk or if your business meets any of the 30% criteria listed in the graph below, you might want to maintain a larger balance in your account. For example, a $3.5 million transportation company might aim to have anywhere from $350K to $1 million set aside.
There are factors that might prompt you to adjust your cash reserve up or down, depending on how likely it is that you’ll need funds in the near future. Businesses on the 10% side of the chart typically have steady cash flow, a low likelihood of needing large amounts of cash quickly, and a solid backup plan (like owner liquidity) if they do. These businesses tend to have a diverse client base, a strong sales pipeline, and a high close rate, so they’re not reliant on a single deal to stay afloat. They’re also not in rapid growth mode, which means they don’t need to dip into their funds as often.
Businesses on the 30% side of the chart tend to experience more fluctuations, making them more vulnerable to the influence of individual customers and market shifts. While they might have a substantial amount of business, they also tend to have a higher number of accounts receivable days. Businesses planning for growth also fall on the higher end of this range, as they should anticipate significant outflows and potential unexpected expenses before revenue increases start to materialize.
No matter where you fall on the 10-30% spectrum, it’s a good idea to secure a line of credit in the same amount as your cash reserve—and do so well before you actually need it. A line of credit can be a lifesaver if your short-term cash flow shows that your accounts payable will exceed your accounts receivable for a period of time. You can pay it off once the cash comes in, but in the meantime, it helps keep your vendors and employees satisfied.
Keep Your Cash Reserve in a Separate Account
After determining your cash reserve target, we suggest gradually building toward it and keeping it in a separate account from your tax and operating accounts. This helps you treat it as a distinct entity, out of sight and out of mind. Placing your reserve in an account that earns some interest, such as a high-interest savings account, money market, or CD can help you make even more money off your cash reserve. We recommend that our clients do this. After all, why wouldn’t you want to make money just by keeping your reserve set aside?
Hopefully this helped you determine how much cash you should have in a cash reserve. If you’d like to learn more about how we help small and medium sized transportation and logistics businesses like yours reach their goals, check out our virtual CFO services. You can also schedule a free virtual CFO consultation to get your cash reserve questions answered.
