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How Much Cash?
Use the Cash Conversion Cycle to help determine your liquidity needs

By Kay Rainey

How much cash does a business need? Two months of expenses? Three months? Six months?

It's one of the most often-asked questions in business. The answer? A resounding "It depends!" How fast does the business sell its products or services? How fast does it collect from customers? How fast does it use cash to pay employees and suppliers?

Total liquidity is a better focus for business needs than cash alone. Financial experts use the term Working Capital, defined as Current Assets minus Current Liabilities, to measure the general liquidity of a business.

The Cash Conversion Cycle
The cash conversion cycle is a tool that can be used as a guideline for liquidity. It combines widely used financial ratios calculated with financial statement data. An owner can use this tool, along with a cash forecast, to determine how much liquidity a business needs.

Ratios used in the Cash Conversion Cycle
Days of Sales Outstanding (DSO) = (Accounts receivable x 365) / Annual Net Sales
Days of Sales in Inventory (DSI) = (Inventory x 365) / Annual Net Sales

1. DSO represents the average time required to collect $1 in receivables - from the time the customer is billed (ideally, when goods are shipped or services provided) until that $1 becomes cash. Businesses that sell their goods and services for cash, as in retail, may have a DSO of only one or two days.

2. DSI measures time from the purchase of $1 of raw material to sale to the customer. Manufacturing firms often have a high DSI, while retail DSI is usually lower.

(Adaptation of this concept for businesses that have no inventory will be addressed later.)

Using the formula
Cash conversion is the average time for a business to convert $1 of raw material into $1 of cash - it's figured by adding DSI and DSO. To put numbers to these formulas, assume that a business has a DSI of 91 days (which would be an Inventory Turnover of four times a year), and that the average age of its receivables is 48 days, which is fairly common for a business that sells on Net 30 day terms.

DSO DSI = Cash Conversion Days
48 91 = 139 Days to Cash 

Next step: How long does the business have to pay for the goods and services? 30 days?

Days of working capital needed - Suppliers will carry the costs for about 30 days, but the business needs to have enough internal liquidity to carry it from then until customers pay. In our example, that becomes 139 days to cash, minus 30 days to pay = 109 days of expenses needed.

Average daily cost - Add all costs and expenses on the income statement (or profit and loss statement) that use working capital: Cost of Goods Sold; Operating or SG&A expenses; Interest and Income Taxes (everything except depreciation expense). Then divide by the number of days covered by the statement - 365 if it's an annual statement, fewer if it's an interim statement (A).

Working capital - From the balance sheet, subtract Total Current Liabilities from Total Current Assets, to find the amount of Working Capital (B).

Days of working capital on hand - Finally, divide the amount of Working Capital (B) by the Average Daily Cost (A) to get the number of Days of Working Capital on Hand. Then subtract the Days of Working Capital Needed (D) from the Days of Working Capital On Hand (C).

In our example of 109 days of Working Capital Needed, anything more than 109 is excess Working Capital, and anything significantly less means potential cash flow problems.

Insufficient working capital
Excess working capital may result in less than optimum profitability, since current assets earn very little for a business. Insufficient working capital is more serious, leading to credit problems, expensive borrowing, and inability to take advantage of opportunities.

Short-term solutions include:

additional investment by owners
stretching payments to suppliers
restructuring debt to pay short-term liabilities with long-term debt
increased sales volume
These are only temporary measures, though. Unless steps are taken to retain more of every dollar brought in by cutting costs, liquidity will decline again. In short, the only answer for maintaining liquidity is profitability.


Kay Rainey presents seminars and workshops on financial issues for business owners and managers.

If you'd like to meet with an M&T small business specialist, call 1-800-724-6070 to set-up an appointment.

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