What it means
Every business has cash coming in and going out, and the two rarely match perfectly. A liquidity cushion is the buffer that stops a timing mismatch from turning into a crisis, such as missing payroll or defaulting on a loan payment.
The cushion has two parts. The first is cash and near-cash assets, such as bank balances, money market funds and short-term government securities that can be sold quickly at close to face value.
The second is committed but undrawn credit, such as an unused revolving credit facility, which is only a real cushion if the bank is obliged to lend when called on. How big should it be?
There is no single rule, but many businesses aim for a number of months of operating costs, such as three to six months, depending on how predictable their income is. Seasonal firms, start-ups and companies with large debt repayments due usually need a bigger cushion than steady, profitable ones.
Holding a cushion has a cost. Cash earns little compared with what the same money might earn if it were invested in the business, so a bigger cushion reduces returns.
Finance teams balance this cost against the cost of running short, which can include emergency borrowing at high rates, damaged supplier relationships or lost opportunities. Banks use the same idea in a more formal way.
Regulators require them to hold high-quality liquid assets sufficient to cover a stressed period of cash outflows, and banks report on these cushions to their boards and supervisors. A company can adopt the same discipline by testing how long its cushion would last under a bad scenario.
In practice
Real-world examples.
Example
A seasonal garden centre earns most of its income in spring and summer. The owner keeps $300,000 in a deposit account at the end of the busy season to cover winter rent, wages and stock orders. In a good year the money is barely touched, and in a poor year it keeps the business open until spring.
Example
A software start-up with $1,800,000 in the bank and monthly spending of $150,000 has twelve months of cover. The founders set a rule to begin fundraising once the cushion falls below nine months. They know that raising money usually takes several months, so they start well before the cash is close to running out.
Example
A manufacturer agrees a committed revolving credit facility of $5,000,000 with its bank, and keeps it undrawn. The finance director counts the facility as part of the cushion but also tests whether the bank's terms could allow it to be withdrawn. She reads the covenants carefully, because a breach could cancel the facility at the worst possible time.
Formula
Calculation
Liquidity cushion = cash and near-cash assets + committed undrawn credit. Months of cover = liquidity cushion / average monthly cash outflow.
Suppose a company holds $600,000 in cash and money market funds, and has an undrawn committed credit line of $400,000. The cushion = 600,000 + 400,000 = $1,000,000. If average monthly cash outflows are $250,000, months of cover = 1,000,000 / 250,000 = 4 months. If sales stopped altogether, the company could still pay its bills for four months.Case study
Seen in the real world.
Eastbrook Engineering is an illustrative, fictional supplier to the construction industry. Its owners kept little cash because they preferred to reinvest profits in new machines, and they relied on a bank overdraft to cover gaps.
When a large customer delayed a $900,000 payment by ninety days, the bank reduced the overdraft limit, and the company struggled to pay wages. A hurried sale of a machine at a discount raised the cash it needed but cost the business a valuable asset.
After the episode, in this illustrative case, the owners built a cushion equal to three months of costs, about $750,000, and arranged a committed credit line. Profit fell slightly because of the extra cash held, but the finance director felt the trade-off was worthwhile. Eighteen months later, a second late payment was absorbed without any change to wages or supplier terms.
Watch out
Common mistakes.
- Counting uncommitted overdrafts as a cushion, when the bank can withdraw them at short notice.
- Holding assets that look liquid but cannot be sold quickly in a crisis, such as property or unlisted shares.
- Forgetting that the cushion is spent as soon as it is used, and failing to rebuild it afterwards, which leaves the business exposed to the next shock.
Questions
People also ask.
How big should a liquidity cushion be?
It depends on how predictable cash flows are, but three to six months of operating costs is a common target for small and medium-sized businesses.
Is a credit line the same as cash?
Not quite, because a committed facility is a promise to lend that depends on the lender and the terms, so many firms count it separately from cash.
Does a bigger cushion hurt returns?
It can, since idle cash earns less than money invested in the business, so firms weigh the cost against the protection.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related