What is Cash Balance and Why is it Important?

When you own a small business, cash balances are critical to meeting the liquidity needs of your business. Cash balance and net cash flow can be challenging to manage because of the various decisions that need to be made regarding the cash. 

For this reason, many entrepreneurs make the mistake of neglecting it and instead focusing on what they’re good at, hoping that will fix the issue. However, this will only worsen your cash position, as you must face the problem head on if you want to solve it.

In this article you'll learn what a cash balance is, how to calculate it, and why a cash balance is an essential part of your business’ success. 

What is Cash Balance?  

A cash balance is the amount of money that a company currently has available on hand to offset any unplanned cash outflows. Without this safety buffer, businesses may find themselves unable to pay their bills, pay off debt, or return to investors as a dividend. 

Businesses that experience a significant difference between the timing and amount of cash inflows and outflows are especially in need of a cash balance. A company that has an excess cash balance can experience a cash drag and will often 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 Cash Balance? 

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

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

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

Businesses use the cash flow formula to calculate their cash balance, in order to figure out the total cash available at a certain point in the future or how much they had at a specific 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 the next month, as opposed to the beginning of the current month. 

For example, if you start the month with $1,000, gain $300 through sales, then you make another sale worth $1,200, but the buyer will only pay you in installments across two months, and you spend $1,500 during the month.

Using the accrual accounting method, you'll notice that your balance sheet will show that your business' 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, the 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. 

Why Cash Balance is Important 

When managed properly, calculating your cash balance gives you many advantages and helps grow your small business effectively. 

Exploiting Opportunities

One advantage of a cash balance is that you can exploit opportunities that require cash. These opportunities are typically different from a company's usual course of business, have a short 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 undertake the financial strategy of maintaining a minimum cash balance will have the cash on hand needed to exploit the opportunity. 

Meeting Loan Opportunities

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

When you maintain a good cash balance, it positively impacts these balance sheet items, and ultimately, allows you to qualify for loans that'll help your business grow. 

Strengthening Financial Management

Many small businesses only pay attention to their profits on the income statement and the assets and liabilities on their balance sheet while completely ignoring the cash flow. This ignorance can lead profitable companies to go out of business because they've failed to manage their finances correctly and have struggled to pay their bills. 

With a cash balance policy in place, business owners are forced to identify and assess their mid-term and future cash needs and take the necessary action to meet them, thus helping their business thrive. 

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

Receiving a Cash Balance Plan

Having a cash balance is also beneficial when creating a cash balance plan, much like traditionally defined benefit plans. This 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, and can also includes getting regular statements explaining the value of hypothetical accounts. Employees can expect to receive a cash balance plan document so they can better understand their plan. 

The formula for calculating the benefit is as follows: 

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

Grow and Improve Your Business With QuickBooks Intuit! 

Manage your cash balance takes time and effort. With QuickBooks’ cloud accounting software you can save time on managing your finances, track sales, and access your financial information on the go, so you can get 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 Resource Centre that helps improve your small business' performance.

QuickBooks also provides other tools that are sure to improve the financial wellbeing of your business, like expense tracker and inventory management software.