Operating a business is a practice in predicting the unpredictable. No matter how much preparation you put into forecasting and budgeting, it’s possible for something unexpected to throw you off your plans.
Sometimes, it’s unexpected costs. Others, it’s a rare opportunity that you have to jump on. Either way, you need the capital to get it done.
In times of a cash crunch, it’s common to turn to lending or credit. But the interest costs and disruption to your future cash flow have downstream ripple effects, disrupting your plans even further down the line.
This is why savvy businesses keep cash reserves, and if you manage one properly, you’ll be prepared for any situation while generating passive income.
What is a cash reserve?
A cash reserve is a pool of liquid funds that businesses set aside to cover unexpected expenses, financial emergencies, or sudden investment opportunities.
These reserves are typically made up of cash, although some highly liquid assets or investments may be included. Liquid assets are those that can be easily turned into cash without a significant loss of value.
The purpose of a cash reserve is to be a safety net, providing stability and protecting businesses from needing to turn to high-interest debt. If there’s a need for injection of capital to cover costs or take advantage of an opportunity, those funds are ready and accessible.
The importance of cash reserves
Building and maintaining cash reserves is a decision that helps maintain financial health through unexpected hiccups or opportunities. It may seem counterintuitive to keep money accessible rather than immediately invest it, but doing so creates a foundation of stability that helps businesses thrive.
Financial stability
Cash reserves provide a valuable buffer that protects businesses from financial disruptions. If revenue drops, adequate cash reserves help cover operational costs and keep operations humming.
This financial stability is especially vital for small or medium-sized businesses that don’t have the same level of access to credit lines or financing. These are businesses that are also learning about their markets and revenue trends, thus may not be able to predict or forecast a down period.
Avoiding costly debt
There is a wide array of financing options that can be leveraged in times of need. However, the quicker you need access to capital, the more likely it is that you’ll pay high interest amounts or administrative fees to get it.
Having a cash reserve saves you from turning to high-interest credit cards, emergency loans, or invoice factoring, which strains future cash flows and cuts into your bottom line. Plus, you don’t have to wait for a loan approval when you need that money most.
By avoiding debt and future payments, you maintain control over your financial health and save borrowing capacity for strategic opportunities.
Flexibility
Cash reserves aren’t solely protection from worst-case scenarios, they’re also used to seize opportunities when they present themselves.
You could be presented with an opportunity to buy inventory at a steep discount, invest in new equipment that streamlines operations, or take advantage of a big marketing push. With cash reserves, you can jump on these opportunities without relying on credit or financing.
Having a cash reserve helps businesses keep financial flexibility to strike when the iron is hot, making strategic pivots when the conditions call for it. As the world of business is fast-moving, being financially prepared for change is a way to make the right moves at the right time.
Key benefits of cash reserves
Cash reserves offer benefits operationally and strategically, helping businesses thrive by minimizing risks and maximizing opportunities.
Risk mitigation
Cash reserves help businesses survive through cash flow disruptions, seasonality, unexpected costs, or economic downturns. This protection protects businesses from the financial vulnerabilities that typically come with running a business.
Creditworthiness
Lenders and investors look at cash reserves as a sign of financial health, responsible cash management, and an ability to cover debt payments. This could result in better credit terms, like lower borrowing costs or interest rates.
Operational continuity
Nearly every business has recurring costs like payroll, rent, utilities, or supplier payments. Cash reserves ensure those obligations are met without interruption, maintaining positive relationships with the people who keep your operations humming.
Strategic investment
Beyond covering your day-to-day costs, cash reserves can be tapped into for strategic investment without needing external financing. When the opportunity arises to improve equipment, add to your facilities, or develop new products, you can jump on it without hesitation.
Peace of mind
Beyond the financial benefits, cash reserves help owners and leadership maintain a mental and emotional balance through the stress of running a business. Having confidence that the business can survive a disruption provides the peace of mind to focus on strategic and growth planning.
Example of cash reserves in businesses
Let’s break down how a cash reserve works in practice with an example.
A mid-sized business has monthly operating expenses of $50,000 and is planning on building a cash reserve to cover up to three months of operating expenses, meaning it needs to maintain a balance of $150,000.
They plan on allocating 15% of their monthly profits to their reserve fund, holding it in a high-yield savings account. With an expected monthly profit of $50,000, they plan to transfer $7,500 each month.
From January through June, they accumulate $45,000 in their cash reserve (6 x 7,500).
In July, they incur unexpected equipment repair costs of $20,000. Instead of using its line of credit or an emergency loan, they pull from the cash reserve, leaving $25,000 in the savings account. Once they make their monthly contribution for July, the balance is brought up to $32,500.
In the following months, the business decides to be more aggressive with its contributions to make up for the withdrawal and hit its $150,000 goal sooner. They increase their monthly contributions to 30%, a $15,000 contribution.
From August through December, they contribute $75,000 (5 x 15,000), bringing the balance to $107,500.
During December, one of their vendors is offering them a bulk discount to make some sales before the end of the year. Not wanting to miss out on this opportunity, the business taps into its cash reserve, withdrawing another $10,000, bringing the balance to $97,500.
While the business didn’t hit its desired cash reserve level by the end of the year, making regular contributions already paid off by avoiding using credit to cover the unexpected repair costs or to take advantage of an immediate financial benefit. Plus, they’re well on track to hit their cash reserve target in the coming months, at which point they can slow down or stop their monthly contributions.
How to build and manage cash reserves
Building and maintaining a cash reserve requires careful planning, commitment, and regular check-ins. Here’s your guide to getting started.
Step 1: Calculate your target reserve amount
The general rule of thumb is to maintain a cash reserve of three to six months of operating expenses.
Start by going through your financial reporting to find your monthly expense total. You may have seasonality or peaks in expenses from one-time costs or annual expenses. Account for these by looking at an average over a 12 to 24-month period.
Take this number and multiply it by three and six. These should be considered the upper and lower bounds of what the reserve amount should be.
If your monthly expense total is calculated to be $20,000, you should aim for a cash reserve between $60,000 and $120,000.
Step 2: Consider using a dedicated account
A separate bank account helps keep everyone accountable to the balance and prevents any accidental usage.
Consider using a savings account or money market account that provides interest earnings while maintaining accessibility. This nets the business a return on the funds while maintaining liquidity and flexibility.
Step 3: Have a funding plan
Plan on a set amount that gets transferred into the cash reserve on a set schedule. These could be made on a weekly, monthly, or quarterly basis.
The amount you contribute can be determined by how soon you want to hit your cash reserve goal or as a percentage of your net earnings. Basing it on a percentage of your net profit ensures you’re still allowing use of your retained earnings for investment activity.
For example, if you contribute 30% of net profit to a cash reserve, a $10,000 profit would mean a $3,000 contribution, while a $1,000 profit would mean a $300 contribution. This means you’re consistently contributing more when your profitability allows for it.
Step 4: Establish internal rules for usage
How a cash reserve gets used is up to the business to determine. But regardless of how you plan to use it, it’s important to set guidelines so it doesn’t get overused or treated as cash on hand.
Generally speaking, cash reserves should be used in genuine emergencies or exceptional opportunities that promise financial benefits. It’s up to you to determine what that entails.
For financial hardships, you may want to set a minimal cash level that, if an expense takes you below it, allows for use of the cash reserve. Or, in the case of opportunities, determining what is sufficient enough financial return to allow for its use.
These rules will ultimately be dynamic as the business changes: financial hardship for a small business with minimal credit is different than for a large business with substantial credit. You should evaluate these internal rules regularly, such as on an annual basis.
Step 5: Outline a replenishment
It’s likely that at some point, you’ll need to use your cash reserve. What comes after is a replenishment plan to get it back to the expected level.
This could mean using the same funding strategies you’ve outlined as part of step 3. Alternatively, you may want to take a more or less aggressive approach depending on how much of the cash reserve has been depleted.
What’s important is that you put a plan in place and stick to it. The replenishment phase is just as important as the initial funding phase.
Step 6: Set a cadence for review and adjustment
As the business grows and changes, so too do the operating expenses. As these changes occur, you need to think about how this impacts your cash reserve practices. Your reserve target may change, or maybe your internal rules for usage.
This is especially true if the business is planning to take on more risk to chase potential investments, like a new location or product line. If you’re anticipating a period of heightened costs, you should plan on adding an additional buffer to the cash reserve.
Additional tips and best practices
Managing a cash reserve is an ongoing practice. To maximize effectiveness, follow these best practices:
- Use historical reporting and financial forecasts to identify patterns in your cash flow, anticipating future costs or reserve needs during heightened expense periods
- Plan around seasonality, funding your cash reserve when revenue is high to help the business sustain through a period of lower activity
- Balance the needs of the cash reserve with strategic investment opportunities, as maintaining the cash reserve shouldn’t come at the cost of growth
- Don’t keep your cash reserve in a basic checking account, as you can generate interest on your cash reserve for passive income
Potential risks of holding cash reserves
Cash reserves provide a crucial stability and flexibility to your financial health, but they’re not without potential drawbacks. By understanding the risks, you can plan around them and find the right balance between deploying and maintaining a cash reserve.
The impact of inflation on cash reserves
Inflation is an economic phenomenon where costs increase, and the purchasing power of a dollar drops over time. If purchasing power is dropping, the value of your cash reserve is dropping.
Think of it this way: you have a cash reserve of $60,000 based on three months of $20,000 in operating expenses. If inflation is 2%, those operating expenses would theoretically increase by 2% to $20,400. Your three months of operating expenses are now $61,200, meaning your cash reserve is insufficient.
The Federal Reserve targets an inflation rate of 2%. If you can generate more than 2% of interest on your cash reserve, you’re likely going to come out on top.
The opportunity cost of cash reserves
The money held in cash reserves is money that could have been deployed in the business or invested in high-return opportunities. That money could have been invested in marketing to grow revenue, equipment to streamline operations, or expanding the business with a new location or product line.
Knowing when a cash reserve fits in your financial strategy
A cash reserve isn’t always the best strategy for a business, depending on the state of the business and overall market conditions.
You may want to reevaluate whether a cash reserve is right for you if:
- The business gets access to cheaper, more reliable credit lines
- The economy is in a period of high inflation, devaluing the money kept in a cash reserve
- The business model is changing significantly, resulting in a similar change to expected cash flow or expected expenses
- Leadership is consistently turning down growth opportunities to protect the cash reserve, putting the business in a state of stagnation instead of stability
Remember that cash reserves don’t have hard rules to follow. Your business is unique, and the treatment of a cash reserve will affect that. Think about what role it plays in your operations and how the treatment of it should reflect them.
The difference between cash reserves and liquid assets
Cash reserves and liquid assets are often used interchangeably, but they represent distinct concepts and practices in a business’s financial management.
Cash reserves are funds that are deliberately set aside for emergencies or investment opportunities that the business wouldn’t otherwise be able to afford. They are savings, often held in a separate account, that provide a business with stability against the ever-changing conditions it operates within.
Liquid assets are a broader category of assets that can be easily converted into cash without a loss of value. A cash reserve would be considered a liquid asset, but the term also encompasses checking accounts, stocks and bonds that are easily sold, accounts receivable on short payment terms, and any other assets with high convertibility.
All cash reserves are liquid assets, but not all liquid assets are cash reserves.
Both are important to a business’s financial health. Having substantial liquid assets indicates strong short-term financial positioning and an ability to cover upcoming payments, while having an adequate cash reserve shows preparedness for the unexpected.
Better cash management with expense tracking software
Making and maintaining a cash reserve goes hand-in-hand with budgeting and expense management. Once you make a plan for how money is getting allocated, you need a tool that helps you keep that spending in check and make room for cash reserve contributions.
That’s where BILL Spend & Expense comes in, a combination of AI-powered expense management software and company cards with spending restrictions that protect every dollar. Spend less time reviewing receipts and approving every purchase with a platform that controls spending, auto-categorizes transactions, and matches receipts to transactions.
Reach out for a demo and see how our integrated platforms are helping businesses like yours save time, cut down on errors, and get protection from fraud.
Frequently asked questions
Is a cash reserve a savings account?
A cash reserve isn’t the same as a savings account, though a savings account is commonly used to hold a cash reserve. Cash reserves are funds that are set aside for emergencies and opportunities that can be held in any type of highly liquid account, including savings accounts, money market accounts, or short-term treasury bills. It’s common to use a savings account for a cash reserve because they’re easily opened, generate consistent interest, and come with FDIC insurance protection.
What is a good cash reserve?
The general rule of thumb for a cash reserve is to have enough set aside to cover three to six months of operating expenses. For example, if your business has $30,000 in monthly expenses, the ideal cash reserve falls between $90,000 and $180,000.
Some additional considerations when determining your ideal cash reserve level include seasonality, revenue stability, growth stage, industry volatility, and changing market conditions. The more unpredictable a business’s revenue and expenses, the larger the cash reserve should be.
How long does it take to build a cash reserve?
The timeline for building a cash reserve depends on the desired cash flow level and the funding strategy. Highly profitable businesses can build a cash reserve quickly by setting aside a portion of monthly profits, while small-scale businesses may need to take longer or be more aggressive with their funding strategy.
What’s important is that you have a plan and stick to it. How fast you build a cash reserve isn’t as important as the commitment to contribute to the cash reserve.
Can cash reserves be invested?
Cash reserves can be invested so long as they are in highly liquid investment mechanisms like short-term treasury bills or high-yield savings accounts. Generally speaking, the higher the returns on an account, the less accessible the funds are. You need to balance the accessibility of the funds held in a cash reserve against how much interest you want to earn on the investments.
When should you use cash reserves?
Cash reserves are intended to be used for unexpected emergencies or exceptional opportunities that offer clear and measurable financial benefits. Some examples of appropriate use of a cash reserve include:
- Emergency repairs or replacements
- Covering expenses during a revenue shortfall
- Managing unexpected inventory needs given supply chain disruptions
- Capitalizing on time-sensitive opportunities like bulk purchase discounts
- Covering costs during a business restructuring or shakeup
Cash reserves should not be used to cover routine operational expenses that can and should be strategically planned for if operations have been consistent, or for nice-to-have purchases. Think about whether the usage is necessary and immediate, or provides a clear financial benefit that the business cannot afford to miss.
What’s the difference between cash reserves and emergency funds?
Cash reserve and emergency fund are used interchangeably when referring to money set aside for unexpected disruptions. However, cash reserves can be used more broadly, deployed for investment or strategic opportunities. In most cases, you can use either term to cover the same funds, but some businesses will hold both a cash reserve and an emergency fund with different use cases for each.
