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Running a business

What is a cash balance and why is it important?

By QuickBooks Australia

Published onJune 10, 2024

When you own a small business, cash balances are critical to meeting liquidity needs. But cash balance and net cash flow can be challenging to manage because of the various decisions you must make regarding the cash.

For this reason, many entrepreneurs make the mistake of neglecting it and focusing on what they’re good at, hoping it will fix the issue. However, this will only worsen your cash position.

You must face your problem head-on if you want to solve it. Read this article to discover what a cash balance is, how to calculate it and why a cash balance is an essential part of your business’ success.

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What is a cash balance?

A cash balance is the amount of money a company currently has available. This money is kept on hand to offset any unplanned cash outflows. If not for this safety buffer, businesses can find themselves unable to pay their bills.

The cash balance is typically used to pay off debt or is returned to investors as a dividend. Businesses that experience a significant difference between the timing and amount of cash inflows and outflows especially need a cash balance.

When companies have an excess cash balance, they experience a cash drag and tend to miss out on investment opportunities.

On the other hand, companies that are low on cash might miss big opportunities due to insufficient funds and will often be forced to make undesirable transactions to improve their financial statements and gain operating capital.

How to calculate a cash balance

Before calculating your cash balance, you must understand exactly what cash flow is.

Cash flow is a measure of cash that flows into and goes out of your business. A company’s cash flow statement is divided into three sections: operating, finance and investing. All three sections consist of cash inflows and cash outflows.

Cash inflows are the funds that come into your business each month. This may include income from sales, investments and loans. Cash outflows are the funds going out of your business. These will include any money spent on staff, supplies and loans.

Businesses use the cash flow formula to calculate their cash balance, meaning they can figure out the total cash they'll have available at a certain point in the future or how much they had at a certain point in the past.

Cash flow formula:

Cash balance = beginning cash balance + cash inflows – cash outflows

Cash balance example

Let's say you want to use a cash flow statement to determine how much money you'll have at the beginning of next month, as opposed to the beginning of the current month.

You start the month with $1,000. You gain $300 through the sales you have made. You make another sale worth $1,200, but the buyer will only pay you in two months. You also spend $1,500 during the month.

Using the accrual accounting method, you'll notice that your balance sheet will show that your business's overall value is still $1,000 at the start of the next month. This is because the cash balance is calculated as follows:

$1,000 (cash balance) = $1,000 (beginning cash balance) + $300 (sales) + $1,200 (accounts receivable) - $1,500 (expenses).

However, your cash flow statement will show that your account is overdrawn. Unless you decrease your expenses or increase your sales during the month, you'll be left with a -$200 balance.

This is why managing your cash balance is so important. It helps you ensure you can invest in opportunities and have enough cash to pay your bills. This is especially helpful when your finances become too complicated to keep track of in your head.

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4 reasons why a cash balance is important

When managed properly, calculating your cash balance gives you many advantages and helps grow your small business effectively. Below are four reasons why cash balance is important.

1. More opportunities

One advantage of the cash balance practice is that you can exploit opportunities that require cash. These opportunities are typically different from a company's usual course of business, have a minimal window or appear at the last minute.

For example, a supplier could discontinue a particular item and then sell that item at a big cash-only discount to clear out that inventory. Customers who practise the financial strategy of maintaining a minimum cash balance will have cash on hand to exploit the opportunity.

2. Meeting loan requirements

You'll find that most loans expect that businesses meet specific balance sheet requirements and comply with certain ratios. Lenders often specify three balance sheet items: working capital, current assets and cash on hand.

When you practice maintaining a good cash balance, it positively impacts these balance sheet items. Ultimately, it allows you to qualify for loans to help your business grow.

3. Strengthening financial management

Many small businesses only pay attention to their profits on the income statement and assets and liabilities on their balance sheet but completely ignore the cash flow.

This ignorance can lead profitable companies to go out of business because they cannot manage their finances correctly and struggle to pay their bills.

With a cash balance policy, business owners are forced to identify and assess their mid-term and future cash needs and take the necessary action to meet them. This type of practice is what allows businesses to thrive.

It forces you to adjust operating activities and financing policies, sales and activities to maintain the minimum cash balance despite the changes in accounts receivable turnover and sales.

4. Receiving a cash balance plan

Cash balance is also beneficial in creating a cash balance plan, much like traditionally defined benefit plans. The plan offers an individual account to each covered employee and provides them with a lump sum.

This is usually a combination of compound interest over time and employer contributions. It also includes getting regular statements explaining the value of hypothetical accounts. Employees can expect to receive a cash balance plan document to understand their plan better.

The formula is as follows:

Annual benefit = (wage x pay credit rate) + (account balance x interest credit rate)

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If you want to manage your cash balance well, it will take time and effort. QuickBooks’ cloud accounting software will allow you to save time on managing your finances, track sales and access your financial information on the go, providing you with a more accurate view of your business.

Did this article help you gain a better understanding of cash balance? You can access more informative articles like this on the QuickBooks blog that helps improve your small business's performance. QuickBooks also provides other software like an expense tracker and inventory management software. These tools are sure to improve the financial well-being of your business.

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What is a cash balance and why is it important?

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What is a cash balance?

How to calculate a cash balance

Cash balance example

Grow Your Business with QuickBooks

4 reasons why a cash balance is important

1. More opportunities

2. Meeting loan requirements

3. Strengthening financial management

4. Receiving a cash balance plan

Grow and improve your business with QuickBooks Intuit!

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