What is the real cost of "sitting on cash"?
You worked hard for your money. It doesn’t matter if your cash came from raising a round, or because you are cash flow positive. The fact is, it’s critical for you and your business.
With something so important as your cash. You need to understand the cost of NOT putting it to work. Sure, knowing you have it in the checking account provides a sliver of safety and comfort. But do you know you can actually have a negative return by leaving it there?
During a recent conversation with a potential client, they asked,
“What return do I get on my money if I do nothing with it?”
To many this has a straightforward answer. If my bank is paying me X, then I earn X multiplied by the amount of money I have with them. The math seems simple but it does not give you the real answer.
The real answer comes by accounting for inflation and taxes which results in the real return. By understanding real returns you will see why holding large amounts of cash may not be the best move.
Definition of Real Returns
The US Securities & Exchange Commission (SEC) provides a clear definition of real returns:
“Real return is what is earned on an investment after accounting for taxes and inflation.
Real returns are lower than nominal returns, which do not subtract taxes and inflation.”
Many investors usually do not account for future taxes or inflation when analyzing an investment. Because of this they may opt for one investment over another. And in some cases this costs them.
Reality of Real Returns
For the following example we are talking specifically about cash and cash equivalent securities. You can also use similar math and data when analyzing stock indices and bonds.
Aswath Damodaran is a finance professor at NYU. He tackles all things related to corporate finance and valuation. One of the wonderful things he does is track and monitor historical returns of stocks, bonds and 3-month bills. Because he is a nice guy, he even publishes his data.
If you wanted to calculate his data on your own you would use this formula.
Here is a table showing real returns on cash equivalents from Aswath’s data. For 2021, we used the most recent CPI data from the Bureau of Labor Statistics.
The table shows the effect inflation can have. Because of this you need to have a plan of attack or you are at its mercy.
Inflation Attack Plans
Here are two paths you can take concerning inflation. One is not better than the other because there is no magic bullet. They are only starting points.
1. Eggs in One Basket
Having all of your cash in one location gives you a sense of comfort. Anytime it is needed, it is available. The downside is there can be a loss of buying power thanks to inflation.
This tends to be the route novice entrepreneurs or very conservative entities take. It is also the easiest to manage because there are few moving parts. Likely one bank account and one corporate credit card.
Even in this simplicity there is risk. FDIC protection is capped at $250k per bank account. That means anything above $250k is at risk if the bank fails. To correct this risk you have to think more creatively. We discuss one solution in the next section.
2. Fight Inflation
If you want to tackle inflation head on consider this 5 part plan:
Get an Investment Policy in Place
First step should be to implement a cash management plan and investment policy. This will be your playbook of how you will manage your cash. Things like, how much will be in the safety bucket, what you can & can not invest in, who will be in charge, etc.
If the idea of creating an investment policy seems impossible. Consider using the SIPS(Standard Investment Policy for Startups). We created the SIPS as a free resource any company can use and tailor as the company grows.
Follow the link and download the document to get started. In 15 minutes you will be set. If you want help just reach out to us.
Set Up Safety Bucket
A solid plan needs to have a safety cushion in case things go wrong. 3 - 6 months of your current burn is a good starting point. We have seen people even go up to 12 months.
This cash would be sitting in your operational account or in US T-bills. Remember, any amount over $250k in a single bank account carries risk. The easiest way to eliminate that risk is by putting your cash in US T-bills.
US T-bills are backed by the US government making them to be considered the safest asset in the world. They also give you next day liquidity in the event you need the cash.
To learn more about T-bills check out our post, “The Government Bond Market”.
Put The Rest To Work
Once your safety bucket is full. You start putting the rest of your cash to work to earn interest. Things like bank certificates of deposit and investment grade corporate bonds are where this money can go.
Looking back at Aswath Damodaran’s data. Real return on investment grade bonds in 2019 & 2020 gave you a positive real return after inflation. That means you earned more on your cash than inflation destroyed. You might have also extended your runway.
You can learn more about corporate bonds in our post, “The Corporate Bond Market”.
Don't Binge on Debt
Lines of credit and venture debt can be tempting as your company grows. The key is to use debt when it is advantageous. Don’t take on debt just because it’s being offered to you.
Check out the article, “Extending Your Runway Without Raising Equity” from Aaron Spool of Eventus Advisory Group. It gives you a great high level view of if / when debt may make sense for your company.
Create Team Buy In
Key team members should be aware of the cash management plan & investment policy. This keeps all teams aligned with cash inflows and outflows across all functions.
The historical data from Aswath Damodaran shows you can earn negative real returns when leaving cash in the bank.
If you plan to tackle inflation you will need a plan of attack. A safety bucket and an investment policy are two key steps. Putting your money to work and taking on debt in moderation solidify the plan.
Inflation is an unruly beast. With a plan in place and periodic review you can reduce its effect. It won’t be easy but it will be worth it.
To learn about how inflation is currently affecting the economy, check out our piece, “Inflation - Do You Feel It Yet?”
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