Most business owners will quickly admit that things don’t always go according to plan. Everything is smooth sailing, and then an unforeseen circumstance knocks you over like a tidal wave.
Maybe a crucial piece of equipment broke down and needs to be repaired and replaced. Perhaps a key customer is late paying an invoice. Maybe business is slower than usual and your cash flow is suffering as a result.
That’s where your cash reserves come in. They’re the life raft you can cling to when unexpected expenses threaten to sink your business.
What are cash reserves?
Cash reserves are your business’ emergency fund. It’s money that you’ve intentionally set aside and is immediately accessible to you when things get tight.
While the term “cash reserves” might make you picture piles of bills tucked into a savings account or under your mattress, your cash reserve account doesn’t need to be only cash.
Short-term, liquid investments like money market funds or liquid assets that can be easily and quickly converted to cash can also be counted in your amount of cash reserves.
Why are cash reserves important?
Cash reserves are important because they can help you protect your businesses by providing cash flow in the event that unexpected expenses arise or revenue drops. An emergency fund can help you cover expenses without having to get a loan or stacking up credit card debt.
Have you heard the sentiment about saving for a rainy day? Well, that’s the main benefit of your cash reserves—that amount of money you’ve set aside will be your umbrella when your business is in the middle of an unanticipated downpour. As much as you like to think that your business and cash flow are stable and predictable, plenty of surprises can come swooping in from left field.
Just look at the major impacts the COVID-19 pandemic has had on small businesses across the United States. Recent data from Yelp shows that nearly 100,000 businesses have permanently closed as result of the coronavirus. When small business owners needed to shut down in the interest of public health, many didn’t have the necessary cash reserves to sustain them.
Although the pandemic was nearly impossible to plan for (and very few business owners can keep enough liquid cash on hand to carry them through months of shutdowns and halted business anyway), it’s worth noting that many small businesses don’t keep nearly enough money in their reserve funds—even when things are “normal.”
A JPMorgan study of 597,000 small businesses found that 25% of small businesses held fewer than 13 cash buffer days in their reserve. A separate survey from the Federal Reserve Bank of New York found that 47% of small business respondents admitted they would have to use personal funds to support their business through a rough patch.
Cash reserves will keep your business afloat when faced with unpredictable expenses or circumstances.
How much should you keep in your business cash reserve?
Generally, it’s a good idea to keep enough cash on hand to cover your business expenses for three to six months. You can determine the actual dollar amount of cash needed in your emergency fund by considering the following factors:
- How much cash does your business use?
- How much cash will your business need in the future?
- What sources of cash are available to your business?
You need to have enough cash set aside in short-term investments, a savings account, or checking account that you can access during a rainy day. But there’s not a one-size-fits-all amount that applies to every business. These questions can help you determine the right amount for your business.
How much cash does your business use?
At a bare minimum, your cash reserves need to be able to cover your operating expenses for the amount of time you determine.
Take a look at your monthly cash flow statement and other financial statements to get a grasp on how much your business spends each month. If your business stops bringing money in, your emergency fund needs to be able to cover your expenses until you’re earning income again.
How much cash will your business need in the future?
Your cash reserves don’t just need to sustain your business if something happens tomorrow—they need to keep you afloat if something happens next year. Or the year after.
That’s why you need to think longer-term and account for the future of your business. Are you growing rapidly? Bringing on new employees? Expanding your office, storefront, or facility? Keep in mind that growing businesses generally require more cash on hand, so you’ll want to build those future expenses into your cash reserves.
What sources of cash are available to your business?
When thinking about your cash reserves, don’t only think about digits in a bank account. What are other ways you could get cash in a pinch? For example, could you acquire financing? Could you sell an asset?
Liquidity is important to consider here. When you’re experiencing a cash shortage, time generally isn’t on your side. Only count things in your cash reserves if you know you can get the money quickly. Long-term investments, for example, shouldn’t be factored into your reserves.
How to calculate your cash reserve
There are a number of factors to consider when determining your reserve requirements, or how much cash is enough cash for your business. Here are a few simple steps to calculate your own cash reserve.
- Determine the number of months you want to cover with your cash reserves. Experts typically recommend having enough cash to cover three to six months of operating expenses, so try to stick within that range.
- Review a cash flow statement from your last year of business. If you don’t have a cash flow statement to reference (because you’re a startup that hasn’t been in business long enough), use any financial statements you do have access to in order to make some estimates or projections.
- Find your total business expenses for the given year.
- Divide your total expenses by 12 to represent the 12 months in each year. That will give your typical expenses per month.
- Multiply that number by the number of months you determined in the first step. That gives you the total amount you want to keep in your cash reserves.
For example, if your business had $25,000 in expenses last year, you would divide that by 12 (for 12 months) to get approximately $2,083. Multiply that by six to represent the six months of expenses you want in your cash reserves, and you get a total of $12,500. That’s how much you should aim to keep in your business’ reserve fund.
Remember that this basic equation gives you a starting point, but you’ll want to adjust based on your answers to the previous questions or other factors, such as the potential seasonality of your business and cash flow.
How to create a cash reserve
If your eyes grew wide at the equation above, we don’t blame you. It’s tough to set money aside as a business owner. Now that you have a handle on the total amount you need, let’s talk through a couple of strategies to build your cash reserve.
1. Set a monthly savings goal
Trying to save a huge amount of money overnight feels overwhelming. You won’t stock your emergency fund in one swoop, but you can make this process more manageable by setting a smaller, monthly goal for yourself.
Do you want to set aside a certain percentage of your profits each month? Or do you want to set a monthly dollar amount to target?
Breaking down your cash reserve goal in this way is far less intimidating, and you’ll feel motivated to keep going when you see the number growing in your savings account.
2. Treat your cash reserves as non-negotiable
Would you not pay your employees? Or skip your electric bill? We didn’t think so. These fixed expenses are built into your business budget, and your cash reserves need to be too.
Until you’ve stocked your emergency fund with enough cash, you need to treat it as a fixed expense. This will keep you accountable for actually filling it up, rather than treating it as something to do when you feel like you have extra money to throw at it. If you find it’s challenging to keep track of your budget, using software to automate your savings or trying techniques like envelope budgeting may help you build your emergency fund.
3. Create guidelines for tapping into your cash reserve
You don’t just need to build your cash reserve—you need to manage it. It shouldn’t be something you’re tapping into to cover your expenses every month. It needs to exist only for emergencies and unexpected expenses.
Create guidelines or criteria for when you can and can’t access your cash reserves. This will make sure it truly is your rainy day fund and not just a glorified expense account.
Undercapitalization and overcapitalization: What to consider
When figuring out how much you need in your reserve fund, you’ll likely run across the terms undercapitalization and overcapitalization. Here’s a simple way to think about these concepts as they relate to your cash reserves:
- Undercapitalization: Not having enough money in your cash reserves.
- Overcapitalization: Having too much money in your cash reserves.
Both of these can cause problems for your small business. Undercapitalization means you won’t have adequate cash to cover unexpected expenses. However, hoarding money in your cash reserves isn’t wise either. Overcapitalization could mean that you’re skipping out on positive business opportunities in favor of keeping your cash.
Additionally, interest rates on savings accounts or other cash reserve accounts are at historic lows, meaning you won’t be earning much. You might be better off investing that money back into your business to support growth and development.
Sources of funding for small business cash reserves
Generally, the best source of funding for your small business’s cash reserve is you. As the business owner, commit to setting aside some money every single month until you’ve built up an emergency fund you’re comfortable with.
Another way to keep cash on hand is to keep a business reserve line of credit that automatically moves money into your checking account when your balance dips below zero.
Your cash reserves are your umbrella on a rainy day
We all know the sentiment about saving for a rainy day. And unfortunately, weather forecasts aren’t always accurate—which means a downpour can spring up when you were expecting nothing but sunshine.
In those cases, you’ll be glad that you built some solid cash reserves. Use this as your guide, and take comfort in the fact that you have an umbrella at the ready to get you through those pop-up showers.
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