Over the years, I’ve asked this question to my banker friends: “what’s our minimum cash balance?”
The topic would come up from time to time, but not very often because in the high margin industries of biopharma and high tech, there’s always been ample cash lying around.
Unsatisfactory answers
The responses I received were typically one of two types:
- Peer benchmarking: this answer usually came from investment bankers. They would data mine and show all sorts of comparisons: cash as a percentage of revenue, cash as a percentage of operating expenses, cash over market capitalization, absolute cash balances, average cash over the last three years, etc. The list might as well be infinite as the data can be cut any way you want.
- Computational alchemy: this was when I channeled the question to the bank’s geek department (their official name changes over time and varies by bank). They would come back with tons of statistical charts, monte carlo simulations, VaR and CVaR models that looked at the company’s operating and free cash flows over time, overlay assumptions of future financial policy, working capital, etc.
None of the answers has been truly satisfactory to me, but we moved on. It seems that sometimes we look for a good answer, instead of the real answer. (side note: James Altucher says that there’s always a good reason and the real reason).
Back to basics
There has to be a real answer to the minimum cash balance question, so let’s call the voice of reason: personal finance. When I feel confused in corporate finance world, many times I ask myself this:
“what would I do if this was my own business or I was managing my household finances?”
Let’s think about it.
Suppose this is my monthly budget:
This budget allows me to save $2,000 per month.
Stress scenario
Now, what if I lost my job in the middle of a severe economic crisis? Let’s assume that finding a similar job would take me two years.
What could I do in the meantime? I’ll be optimistic and think that I can get a job at my local Starbucks for $2,000 per month (after taxes).
Some of my discretionary spending would have to be decimated and I’d need to be extra thoughtful about capital allocation. Perhaps I should spend more in the education category to sharpen my professional skills.
As you can see, I’ve kept most of the non-discretionary items intact and have a $4,800/month shortfall. I also left family support unchanged in case my mom is reading this.
If it’ll take me two years to find a new job, then I should keep $4,800 x 24 months = $115,200 in cash.
Three-variable problem
There are many ways to estimate a minimum cash balance and underpinning it all are three questions:
- How long do you think the bad period will last? In the personal finance example: two years
- How severe will be the hit to your sources of cash? In the example above: 80% reduction
- What’s discretionary vs. non-discretionary? Also, you need to agree on the order of importance of each line item
You can debate with your teams as much as you want, but once you agree on the answers to the three question, you will reach a logical conclusion.
Company minimum cash balance
Example of a company budget. Thinking in cash terms is best, but you can use accounting as a decent proxy.
Now, let’s imagine a stress scenario and ask ourselves the three questions:
- How long do you think the bad period will last? Let’s keep it consistent with the personal finance example at two years
- How severe will be the hit to your sources of cash? The assumption is a 50% hit to unit demand, so revenue and cost of sales are cut in half
- What’s discretionary vs. non-discretionary? Let’s agree that R&D is non-discretionary, SG&A can be reduced by 25%, interest and debt payments are non-discretionary, but that we are comfortable suspending dividends and share repurchases.
This is how it looks like then.
Minimum cash balance: there’s a $100M shortfall in the year. If the following year is similar, then the company’s minimum cash balance is $200M.
Bonus section: other elements to consider
Because, of course, things are sometimes more nuanced, here are some other things to think about while solving the minimum cash balance puzzle.
- Dividend policy: are we comfortable suspending the dividend? Shall we continue paying a dividend, even if it’s a small amount?
- Credit ratings: do we care about credit ratings? Do we want to preserve a certain profile? What’s our communication strategy with the credit rating agencies?
- Cash on hand vs. access to capital: which comes first under normal and under stress conditions?
- Agility: how fast can we adjust our expenses to changes in the environment?
Conclusion
In conclusion, I propose a simple approach. No need to over-engineer things. At the end of the day, it’s just cash.
Just make sure you ask yourself the three questions:
- How long do you think the bad period will last?
- How severe will be the hit to your sources of cash?
- What’s discretionary vs. non-discretionary? Also, you need to agree on the order of importance of each line item