One of the most common questions I get from small business owners and entrepreneurs is what to do with excess cash from their business. My first response is a congratulatory handshake on a job well done as having surplus cash from any entrepreneurial endeavor is a problem all business owners dream of. So if you're running a business or side hustle that's starting to generate positive cash flow, keep up the good work!
Now that I've placated your ego, let's get real for a moment. Liquidity, or being able to quickly access cash is one of the most valuable assets you can have in business. Cash serves as the lifeblood of your enterprise and can help keep you afloat when times are tough, or allow you to capitalize on an opportunity when it arises.
So when your business leaves you with a slug of dough that you're unsure whether to reinvest back into the company or save personally in the stock market, here are 5 questions you should ask yourself before making the final decision.
1. What stage of business am I in?
If you're in start-up mode with only a year or two under your belt, more than likely your business will require every bit of cash you have to offer. But as you continue down the path towards maturity, cash may start to serve a different purpose than survival, thus you'll want to pay close attention to what stage of business you're in.
For instance, if you've entered the growth stage of your business where sales are booming, profit is rising and competition is emerging, then cash may be better deployed into developing a new product or service based on market demand. If, however you're in a more mature stage of business where systems and operations are well established, margins and cash flow are consistently increasing, albeit at a moderate pace and your cash reserves and liquidity are in good order, then it may make more sense to diversify outside your business by investing in an IRA or an employer-sponsored retirement plan.
Whatever stage of business you're in, it's always good to take a step back and re-assess what's most important to your and your company at that time.
2. How much working capital do I have?
In his book "Shut Up and Listen!," Tilman Fertitta, star of CNBC's Billion Dollar Buyer, emphasizes the importance of business owners knowing their numbers, specifically their working capital. To quote Fertitta: “The biggest issue that small businesses face involves working capital, because they have to pay for everything upfront. When things are bad, eat the weak and grow your business. Never put your lifestyle ahead of the growth of your business. Know your numbers.”
Powerful words of wisdom to say the least!
Working capital is nothing more than your current assets less your current liabilities. For example, let's say you have $50,000 cash in the bank, $100,000 due from customers and $200,000 in inventory. Additionally, you currently owe $70,000 to your vendors, have $100,000 drawn against your line of credit and a business credit card balance of $20,000. In this case, your working capital would be $160,000 (Cash, accounts receivable and inventory, less all liabilities due within one year).
Working capital is a critical measurement of the financial health of your business and your ability to operate in an efficient manner. If one of your customers places an unusually large order that requires a significant amount of your time and resources, then decides to pay 90 days later, it helps if your business has sufficient cash and working capital to deliver in a timely fashion.
While there's no required working capital minimum all companies must abide by, no one knows your business better than you. Be sure to know what is costs to operate each month, taking into account how quickly your customers pay, how quickly you pay vendors and address any gaps. Without positive working capital, there is no business. Without the business, there is no excess to cash to invest...plain and simple.
3. What does my cash flow look like?
In addition to working capital is cash flow, or your company's ability to create more inflows than outflows from operations. The easiest way to see how much cash your company generates in a given time frame is to compare your total cash balance from the beginning of the period to your balance at the end. Did it go up, or down? If you're reading this, more than likely it went up which means your business is cash flow positive.
But just because cash increased doesn't necessarily mean business is profitable. You could have sold an old piece of equipment or received proceeds from a loan you were just approved for, both of which are separate from your company's ability to sell a product or service for a profit.
That is why it's good to pay close attention to your cash flow from operations, which can be found at the top of your Cash Flow Statement. This will show you how much money was earned from day to day operations and provide clarity on where to excess cash can be deployed.
If operating cash flow is consistently positive and abundant, maybe it's time to consider diversifying your efforts by setting some cash aside for personal investment. Conversely, if cash flow growth has just begun accelerating, you may be more inclined to reinvest back into the business.
4. How much risk do I want to take?
While the historical average annual return for the stock market has been around 10%, past performance is no guarantee of future results. If you started investing money in the S&P 500 towards the beginning of 2000, you'd have lost over 42% by the end of 2002. And in 2008, you'd have seen your investments drop close to 40% in less than a year.
Obviously, risk is inherent with any type of investment whether it be the stock market, cryptocurrency or real estate. For business owners, often their most valuable asset is their business which, depending on the industry, can also be their riskiest investment. According to the Bureau of Labor Statistics, only 50% of business survive after five years with a mere 30% making it past ten.
With those odds, it helps to look at your business as an investment, much like you would a stock or a mutual fund. To do this, you'll want to first understand the risks associated with your industry and how they impact your business. Do revenues fluctuate drastically each year and if so, why? Are you reliant on a handful of customers that make up a large percentage of overall sales? What external market factors could significantly hinder your company's performance, and are out of your control?
If, for instance you're in the restaurant or construction business, you may decide to park excess cash in a safe, liquid investment given the degree of risk associated with these industries. On the other hand, a business owner running a more mature and stable manufacturing company may be more comfortable building up her Roth IRA or 401(k) comprised of large-cap growth stocks.
Regardless of where you stand, assessing and managing risk is an integral part of the investing process, be it a small-cap tech stock or R&D for a new product line.
5. What is my expected return?
Once risk is defined, you'll then want to assess your potential return. This may be easier to do within your own business than say Apple or Google given your knowledge and experience in owning/operating a privately held company. Additionally, you'll have quick access to key financial data and historical trends (Assuming of course you or your accountant are keeping up-to-date records) that will show you how well your business is doing and aid in calculating an expected return.
One piece of financial data to keep an eye on is your net margin, or the percentage of revenue left over after subtracting all operating expenses of the business. This figure is important because it shows how effective your business is at turning revenue into profit. So if your company is generating a $50,000 net profit after expenses on $200,000 in total sales, your net margin, or return on revenue is 25%.
Once you've determined your net margin, compare it the average market return which as I noted above in Question 4, is roughly 10%. Which one is higher? Often you'll find that small business ownership offers much more lucrative returns than the stock market and thus, your decision to reinvest cash back into the business may be a no-brainer. However, you may have a considerable amount of your wealth tied up in the business and conclude derisking through stock and bond market investing is more valuable than maximizing returns.
What's next?
My goal here was not to provide a definitive answer to the question of whether to invest in the stock market or your business but rather offer a self-reflective framework to assist you in determining what's right for you and your company. The fact is, there is no right or wrong answer as each business owner has his or her own set of goals, tolerance for risk and unique set of idiosyncrasies specific to their company.
However, the one consistent variable present in every question listed above that will undoubtedly make your decision process much easier is knowing your numbers! There's nothing I can stress more than being able to understand how cash moves in and out of your business. At a minimum, you should be able to quickly state your current working capital, gross margin, net margin and average monthly cash flow at a moment's notice. If you can't, ask your accountant or CPA or financial advisor to sit down and explain it until it becomes second nature.
In addition to knowing your business finances, it pays to be knowledgeable on the personal side as well. You don't have to read the Wall Street Journal daily or have CNBC on 24/7 necessarily, but it's good to be familiar with what's happening in the economy and the financial markets. Monitoring factors such as interest rates, GDP growth and earnings multiples will keep you well informed and better equipped when you do decide to invest in the stock market.
Comments