Strong Cash Flow Can Hide Weaknesses

 I once worked with a company that was doing very well. The business generated substantial cash, its owners could make distributions, and there was little immediate reason to worry about liquidity. That was precisely when I wanted to talk about cash.

It can be difficult to convince an owner of a successful business to leave money sitting on the balance sheet. Cash that isn't distributed or invested back into the business can feel unproductive. When next month's revenue is expected to look much like this month's, maintaining a large reserve can seem unnecessarily conservative.

But I asked the owners to consider a different question:

                What if the reason we need cash is the reason it stops?

The Cost of a Pivot

Businesses rarely receive advance notice that their existing model is about to become less effective.

Legislation can change. Reimbursement models can disappear. A competitor can enter the market. Referral patterns can change. A major customer can leave. Technology can make a service less valuable. Management may recognize the problem quickly and know exactly what needs to change. But implementing that change takes time and money.

In this case, we considered what a meaningful disruption might actually look like.

Suppose an important source of business declined substantially. We might need six months to develop new referral sources. Relationships would have to be established. Employees might need to be retrained. Marketing expenditures could increase. Services might have to change.

At the same time, we made another important decision: we did not want our first response to be cutting staff.

Our employees represented capabilities and institutional knowledge that we would need for the next version of the company. Losing those people might make the income statement look better temporarily while making the eventual recovery considerably harder.

Instead, we wanted enough financial capacity to tell our team something very different:

Business has changed. For a while, we may ask you to do things differently - we're going to work together to adapt.

That requires a balance sheet capable of buying management some time.

How Much?

Once we stopped thinking about reserves as simply “money sitting in the bank,” the conversation became more useful.

We began building scenarios.

How long might it reasonably take to replace lost business? What would payroll look like during that period? Which expenses would continue regardless of revenue? What new expenditures would a pivot require? How much could safely be invested, and how much needed to remain immediately accessible?

We weren't trying to predict precisely what would go wrong.

We couldn't.

Instead, we were trying to determine what resources we would want available if something went wrong.

A reserve based solely upon historical expenses prepares a company to continue doing what it has always done. A strategic reserve should also consider what it might cost to do something new.

Cash Creates Options

This is where I think many discussions about business reserves become too narrow.

Cash is frequently described as protection against failure. Certainly, it can serve that purpose. But liquidity also creates options.

A company with adequate reserves can tolerate several months of weak performance while establishing a new referral relationship. It can retrain an employee instead of terminating one. It can test a new service line. It can withstand a regulatory change without accepting the first available solution simply because payroll is approaching.

A company without adequate liquidity may recognize exactly what it should do and still be unable to do it. That is a very different kind of financial risk.

Prosperity Can Buy You Time

Eventually, we established a reserve and determined how much should remain liquid versus how much could be invested appropriately.

There was a cost to that decision. Money retained by the company was money the owners couldn't distribute or deploy somewhere else.

But there was also a return that wouldn't appear on the income statement.

The owners could make distributions and capital expenditures with greater confidence because they knew what portion of the company's resources had already been committed to protecting the enterprise. Employees could be managed with a longer-term perspective. And management had room to make decisions based upon what was best for the company rather than what produced cash fastest.

Perhaps most importantly, we had purchased time.

Businesses inevitably experience winters. The objective isn't to know exactly when one will arrive. It is to use the productive seasons to prepare for the possibility. Because once the winter arrives, it may be too late to start storing what you need.