A cash reserve is a set of funds that a company puts aside to handle financial challenges. It is one of the most important financial resources that a company can develop. A reserve provides financial stability and allows you to operate the business more effectively. Unfortunately, many business owners ignore the importance of having a cash reserve until it is too late. This article discusses how to build and operate a cash reserve. We cover:
- Why is a business cash reserve important?
- Improve cash flow before building a reserve
- How to build a cash reserve
- How to use a cash reserve
- Cash reserve vs. growth
1. Why is an emergency fund necessary?
Every small business should have an emergency cash reserve. A well-designed and funded cash reserve will help smooth the inevitable cash flow problems that companies encounter. If you run into financial problems, it allows you to keep paying important expenses, such as suppliers and payroll.
Companies often run into problems soon after a recession hits. However, an emergency fund also offers some protection against recessions. It buys you time to plan and respond to market challenges effectively.
A cash reserve won’t offer much protection if your cash flow is not well-managed. The first step to building a cash reserve is examining and improving your current cash flow. This step may help you avoid problems in the first place and reduce your reliance on the cash reserve.
2. How to improve your cash flow
A cash reserve won’t help you much if your cash flow is not managed correctly. Keeping your accounting system up to date may be tedious for some, but it is critical to the success of your business. Fortunately, managing cash flow is not too difficult if you are disciplined. There are four areas you should consider.
a) Update your accounting regularly
Your accounting system is one of the most helpful management tools. However, it is only as accurate as the information in it. Work with a bookkeeper to set up a well-organized accounting system. Make sure the system is updated regularly.
b) Invoicing and collections
An effective invoicing and collections department helps ensure that clients pay as quickly as possible. It’s the most effective way to avoid slow-paying clients and their effects on your cash flow. Follow these steps:
- Update your accounting system regularly
- Have a well-written contract with your clients
- Use delivery acceptance letters
- Send invoices promptly
- Follow up with clients professionally
c) Give net-30 terms only to good clients
Most commercial and government sales are made using net-30-day terms. These terms allow clients to pay in 30 days. Unfortunately, some clients get terms but pay slowly, or not at all. This affects your revenues, cash flow, and profitability. Always check the business credit of your clients before offering terms. Offer terms only to clients with a good track record of paying invoices. Everyone else should pay upfront or at delivery.
c) Consider discounts for early payments
If you have clients that have good credit and you need them to pay sooner, consider offering a discount for early payment. It works by providing select clients with a 1% – 2% discount if they pay their invoice within ten days. When used correctly, early payment discounts help improve your cash flow and client satisfaction.
3. How to build a reserve
This section covers the steps to build an emergency fund for your company. The process is straightforward, especially if you have an accounting system. Here are the three steps you have to follow.
a) Determine the size of the fund
Your first step is to determine the amount of money you need as a safety cushion. This is where an up-to-date accounting system is handy. Most experts agree that anywhere between 3 – 6 months’ worth of expenses is a good target. However, this is a general guideline only. You should consult your team and build a cash reserve that makes you comfortable and meets your objectives. Here is how you calculate the size of your emergency fund:
- Determine how many months you want in the reserve
- Generate a cash flow statement for every month of the last12 months
- Select the months with the highest expenses. The number of months you select must match the number of months you want as a reserve
- Add the costs of the selected months
For example, assume you want to keep a three-month emergency cash reserve:
- Generate a cash flow statement for every month of the 12 months
- Identify three months with the highest expenses
- Add the expenses for the three months identified in the previous step
This method generates a good target size but is not perfect. You might need to adjust this figure if any months had unusually high expenses due to one-off events, such as a large purchase.
Note: Some small businesses prefer to use a Profit and Loss statement rather than a cash flow statement. While it is a simpler method, it can also lead to an undersized reserve.
b) Build the reserve
Building the cash reserve is simple but requires discipline. Deposit a percentage of your profits into the cash reserve account regularly until you reach your desired amount. Your circumstances should determine the percentage you deposit into the bank account.
c) Use a separate account
We suggest keeping the company’s emergency fund in a bank account separate from your other accounts. This account should be used only for the emergency cash reserve. It should not be used for anything else.
4. How to use a cash reserve
You should use funds from the cash reserve only for business expenses that you cannot cover from your regular operating account. Always replenish the reserve as quickly as practical after using it. This ensures the account goes back to its original value and is ready for use again. The biggest mistake business owners make is using their emergency cash reserves for non-emergencies. Don’t use the funds from the reserve account to secure new contracts or make new investments. This is not its purpose. The account should be used for emergencies only.
5. Cash reserves affect growth
There is an opportunity cost to having funds parked in a cash reserve. Those funds cannot be used to buy equipment, and supplies, add new employees or secure new business. Consequently, you will have to give up business growth. This is a reality that many business owners have to accept.
One way to handle this situation is to complement your cash reserve with a line of credit or a similar product. This strategy enables you to use the financing line to grow the business while keeping the cash reserve in place. There are two options that work well for small and mid sized businesses.
a) Accounts receivable line of credit
A receivables-backed line of credit allows you to leverage up to 85% of your accounts receivable. The line works much like a conventional line of credit that adapts to your A/R. Companies can get this solution through an asset-based loan or by using sales ledger financing. These solutions work best for companies that invoice a minimum of $300,000 per month and have a well-established A/R department.
b) Invoice factoring
Companies that can’t qualify for sales ledger financing should consider invoice factoring. Invoice factoring allows you to finance slow-paying invoices from credit-worthy clients. Just like sales ledger financing lines, they improve your cash flow. However, the lines are structured differently and are available to small and new businesses. These lines are provided by factoring companies. To learn more, read “What is factoring?” and “How does invoice factoring work?”
A cash reserve is one of the most important resources that a business can develop. It provides the company with financial stability and allows it to handle cash flow problems more effectively.
Companies should have between 3 – 6 months’ worth of expenses as a reserve. However, this is a general guideline. You should build a reserve that enables you to operate comfortably in your industry. Lastly, you can complement a cash reserve with external financing solutions such as a line of credit, sales ledger financing, or factoring.
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