According to a recent study, 60% of Americans don’t have enough money to cover an unexpected $1,000 expense. What about your business? Do you have enough money tucked away to deal with a sudden expense? If not, you need to give your cash reserve some love.
Cash reserves for business can help you cover larger, sometimes unexpected, expenses. Learn how a cash reserve fund can help prepare your business for unanticipated costs.
What is a cash reserve?
A cash reserve is an emergency fund for your business. You can use a reserve to meet unplanned, short-term financial needs. Instead of incurring debt from a credit card or loan, you can pay for unexpected costs with money from your cash reserve. Usually, you save money for your reserve in a business bank account.
To start your cash reserve, open a new bank account. Your cash reserve account should be separate from your general business bank account and other specific accounts, like a payroll account.
How much goes in a cash reserve?
Now that you can answer what are cash reserves, you may be wondering how much to put into them.
When it comes to putting money into your reserve, not putting in enough can leave you high and dry when an emergency comes your way. At the same time, putting too much in can be costly for your business.
Long story short: you need enough money in an emergency cash reserve to cover unexpected costs, but you also don’t want to forget about investing in your business.
So, how much is just right?
Most financial experts suggest that cash reserves cover three to six months of expenses. But, there’s no one-size-fits-all amount. To figure out your cash reserve’s sweet spot, look at your financial needs.
Your business’s expenses and earnings can show you how much you should put into your cash reserve account.
When coming up with a cash reserve fund amount, look at your:
Cash flow statement
If you have an established company, review your cash flow statement to analyze your past expenses and earnings. Use a cash flow statement from the previous year to find your revenue and money spent.
Subtract the expenses from the revenue to find your cash burn rate (the amount of money you lost from expenses). Multiply your net burn rate by the number of months you want to save for in your cash reserve. For example, if you want a reserve that will last three months, multiply the net burn rate by three.
Budget and projected cash flow
Your business budget and projected cash flow can also help you determine the size of your reserve.
Subtract projected sales by projected expenses. Projections are helpful for startup businesses that do not have previous financial statements.
Make sure your business budget accounts for all your expenses. You need enough money to order materials and pay employees.
Pay special attention to your overhead costs, which you should list in your budget. Overhead costs include rent, utilities, and insurance. No matter how much revenue you make, you have to pay the same amount of overhead costs. You can use your reserve to pay overhead costs when sales are low.
5 Times your cash reserve fund can bail you out
OK, so you know that having extra cash on hand is good for your small business. But, what is a cash reserve really going to do for you?
Here are five things your cash reserve can help cover.
1. Three-paycheck months
If you pay employees using a biweekly payroll frequency, you’re going to have two months during the year with three pay periods instead of two. Depending on how many employees you have, these “extra” paychecks can really add up.
To help cover the costs of three-paycheck months, put money into your cash reserve throughout the year. That way, you can use the funds if your cash flow during three-paycheck months is tight.
2. Slow sales months
Regardless of what industry your business is in, you likely have high and low sales peaks throughout the year. For example, after the holiday season, you might notice a major dip in your sales.
During slow sales months, you might have trouble covering your regular expenses. You can use your cash reserve to help avoid falling into negative cash flow territory.
If you run a seasonal business, managing your cash flow can also be tricky. If you only operate for part of the year, you may need to dip into your reserve to help cover your expenses.
3. New purchases
Sometimes, you need new equipment, software, or machinery to help streamline your business processes. The return on investment might be high in the long-term, but what about the short-term expense of purchasing it?
Instead of taking out loans or driving up your business credit card balance, you can opt to use your reserve to make new purchases.
4. Unexpected expenses
In business, there are some expenses that you can forecast and some that are completely out of your control.
Events like natural disasters could strike, temporarily shutting down business operations, destroying property, and leaving you in a panic over how you’ll cover the costs.
A cash reserve can help protect you from financial issues due to unexpected expenses.
5. Growth opportunities
There are times that you have opportunities to earn more revenue and grow your business. But, these opportunities often require you to spend money first.
A cash reserve allows you to take on the necessary expenses related to growing your business, which could lead to a larger payout in the end.
For example, a customer wants you to complete a big job. You need to pay for the materials, supplies, and payroll before starting the work. Or, you are falling behind on fulfilling customer orders and need to expand. Either way, some extra cash from an emergency fund could help bail you out.
Debiting and crediting your cash reserve account
If you decide to start a cash reserve fund, you’ll be putting money into and pulling money out of it. When you do, you need to make a journal entry so you can stay on top of your books.
When you deposit money into your cash reserve account, you need to increase it through a debit. Because you’re taking money away from your regular cash account, you also must credit your cash account.
Here’s an example of how that would look:
|X/XX/XXXX||Cash Reserve||Deposit to Cash Reserve account||X|
To withdraw money from your reserve account, decrease it through a credit. And, debit the corresponding account that you’re putting the money towards (e.g., payroll account to help cover a three-paycheck month).
Here’s an example of how that would look:
|X/XX/XXXX||Payroll||Withdrawal from Cash Reserve account||X|
To make sure your balance is accurately recorded in your books, you can do a bank statement reconciliation. That way, you can compare your bank statement to your accounting books.
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This article has been updated from its original publication date of August 9, 2016.
This is not intended as legal advice; for more information, please click here.