“Have six months of cash on hand at all times” is one of the recommendations most often invoked by well-meaning observers. It’s the holy grail of financial comfort for many nonprofit managers, the metric that brings color back to board members’ white knuckles, the feel-good threshold for restful nights.
It might also be silly and non-productive.
Let’s examine this supposed standard closely. To put it in numeric terms, if your nonprofit has a yearly revenue base of $1 million, this “silver standard” would mean that you should have $500,000 in cash and cash equivalents at all times. Of course, in some quarters the six-month standard gets reduced to three months. But whether it’s three months or six, the fundamental question is still the same: Why?
Allowing for the fact that good ideas sometimes get turned into blanket recommendations that don’t quite fit all situations, there must be some underlying rationale for this credible-sounding advice. To flip the question around, let’s start from zero to see how much cash the average organization really needs. It’s a verbal version of the individualized calculations every organization should make. In matters of a desirable cash balance, there’s no substitute for old-fashioned, tailor-made number crunching.
Determining Your Cash Needs
Start with the classic determinants of desirable cash balances — the value of the services you’ve already delivered but haven’t yet billed. Add an amount to cover the average length of time it takes for your invoices to be prepared and then paid by outsiders, such as consumers or government entities.
This formula is sometimes known as the cash conversion cycle and it will vary depending on the diversification of your revenue streams. Fundraising, for instance, has its own very favorable cash flow characteristics that are different from earned income. But the concepts are always the same.
Logic and common sense would suggest that any nonprofit would want to have enough cash on hand to cover a normal month’s worth of expenses. And since bad news happens regularly, one might want a cushion of an additional week or two. Even adding a fudge factor of another week, that’s not close to three months. Since the concept is trying to reach six months, there must be some other needs for short-term cash that could get us close to the six-month standard.
Buying Something Big
Here’s one concept: You’re planning to buy something big, like a building. If you foresee this kind of purchase, you’ll need at least your down payment plus cash for renovation, purchasing-related costs, and a host of small to medium sized deposits and advance fees, as well as costs so unexpected no one could possibly have anticipated them.
These will swell your cash account. But unless you’re constantly buying and selling real estate, that amount will eventually go down, probably ending up close to the several weeks’ mark described earlier.
Also a driver of cash, successful development campaigns can temporarily swell the cash flow. Eventually, however, these excess dollars should migrate toward acquiring an asset, increasing the endowment, or supporting programs and so the cash peak is only temporary.
Acquiring an asset and raising funds, then, are nothing more than causes of high cash balances, and only temporary ones at that. You still need to find an enduring reason to maintain half a year’s worth of expenses at all times.
One place to look for such a rationale is the for-profit sector, specifically publicly-held companies. Interestingly, investors and analysts of publicly-held companies see a large cash balance as a potential yellow flag. These seasoned observers interpret lots of extra cash in the petty cash drawer in three ways. Investors are always worried that a lot of cash beyond the amount required for operations is lazy money. You know that kind – sleeps late, plays video games all day, then asks what time dinner will be. When investors see what they think is lazy money, they punish the stock price.
The second reason for such a large company to have so much cash is because its executives feel more comfortable with the money parked on the sidelines. This is what is happening today, with many corporations building up high levels of cash because they don’t believe they’ll be able to invest it safely and profitably in the larger economy. Here, investors reluctantly accept the analysis.
The third reason for public companies to hoard cash is because they expect to start buying other companies. This motivation is more common during times of heavy deal-making or a sharply rising economy. Needless to say, this is the rationale that investors prefer to hear.
There is no nonprofit equivalent of building up this kind of war chest because there is no need to purchase stock and assets in a merger. And nonprofits with substantial sums of unneeded cash can always wisely put the money into their endowment.
Two Final Explanations
There are two final explanations for why six months of cash might be desirable.
One obvious reason why a nonprofit would need six months of cash – or any significant amount beyond routine needs – is to cope with volatility in its environment. Cash flow disruptions unfortunately can occur at any time and have become especially common as state and municipal governments struggle to right-size their finances.
During the past 24 months, several industrialized states have suspended cash payments on nonprofit invoices due to budget crises. This situation alone might be driving up cash balances right now — for those nonprofits that can find the cash — because federal and state cutbacks in this and the next fiscal year may result in funding reductions. A high cash balance is desirable not because it will eliminate the problem but because it can buy time to solve it. Under these circumstances, six months in cash on hand is neither silly nor counterproductive.
And six months in this situation is an arbitrary standard — why not eight or 12? Outside of tough times like these, however, most nonprofits typically don’t operate in highly volatile markets.
Which brings us to the final rationale for six months of cash. If nonprofits operating under normal circumstances without planned major cash drains only need enough cash on hand to cover their routine operating expenses plus a little extra cushion, in whose interests would it be for a nonprofit to carry such a high cash balance?
Answer: Any external party who has placed a large amount of money into the nonprofit and has hopes of getting it back out. Translation: lenders. Lenders’ primary self-interest lies in preserving their capital. The best way to do that is to manage the risks they take with it. What better way to manage the risk of not getting a loan repaid than to ensure that the borrower has six months’ worth of cash on hand at all times?
Cash on hand is a good thing. Too much of it is not. The trick lies in calculating the balance between the two. Manage your cash, don’t let it manage you. NPT
Thomas A. McLaughlin is the founder of the consulting firm McLaughlin & Associates and a faculty member at the Heller School for Social Policy and Management at Brandeis University. He is the author of “Nonprofit Mergers and Alliances” (2nd edition), published by Wiley & Sons. His email address is firstname.lastname@example.org
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