You may have a rainy day fund for your personal finances, but do you have one for your business? An ample cash reserve allows you to cover your basic expenses if a crisis occurs or you suddenly lose a segment of revenue.
Scott Warren, founder of consulting firm Warren Whitney, and business consultant Julie Brander both recommend businesses maintain a cash reserve that covers three to six months of expenses. However, if you’ve got three to six months of cash at your current expense level tucked away, you may be overcompensating. Rather than using your current expenses as a benchmark, you need a rough estimate of what your expenses would be if your sales dried up. You should also consider how likely you are to lose revenue in the first place.
Estimating Fixed and Variable Expenses
Some expenses — like rent, utilities, property taxes, and insurance — are fixed in nature and you’ll pay them no matter what. Variable costs, on the other hand, decrease when sales and production slow down. If you sell products, the cost of raw materials, shipping, packaging, sales commissions, and traveling costs all decrease when sales do. If you sell services and sales decrease, you may be able to let go or reduce the services of independent contractors that are helping you with your current workload. You need to be able to cover all of your monthly fixed costs but only a certain percentage of the variable costs to cover a slowdown in sales.
Analyzing Revenue Risk
The makeup of your revenues affects how large a revenue loss you could incur. If your revenue comes from just one or two major customers, you’re more sensitive to losing a customer compared to a company with multiple small customers. Selling a variety of products and services that span across multiple industries also decreases your revenue risk.
When you consider your revenue risk, think about larger economic and environmental factors. For example, if you sell a luxury or nonessential product, you’re more likely to feel a hit if the economy goes south. A business with lots of emerging competitors and low barriers to entry has a higher risk of losing customers. Make a list of potential reasons for revenue to decline and evaluate how likely they are to occur.
What to Do With the Reserve
You need your cash reserve to be liquid. Still, it’s painful to see your money sit around and not work for you. CDs or bonds often have long maturity dates so they’re not a good investment option. Stock market investments are liquid, but you don’t want to risk losing too much of your cash to market forces. Consider putting the majority of the funds in a high-yield business money market or savings account to mitigate your risk.
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