Why cash reserves are important

Summary

Key Takeaways

Cash reserves offer protection against immediate financial challenges, ensuring stability during fluctuations in sales or unexpected expenses.
Maintaining reserves enables quick action on sudden opportunities, providing the liquidity needed for swift decision-making and investments.
Effective cash reserve management involves maintaining enough liquidity for three to six months of expenses while avoiding excess hoarding that could be better utilised elsewhere.

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A cash reserve protects you against short-term issues such as a drop in sales or an unexpected expense and allows you to seize opportunities as they arise. This article answers the question “What is cash reserve?” and shares tips on how to build and manage yours.

What is cash reserve?

Cash reserve refers to the liquid assets your company keeps on hand to meet short-term and emergency funding needs and can also be referred to as a cash flow reserve. Cash is the most liquid, but short-term stable investments that are not likely to lose value, such as money market funds, can also be cash reserves for businesses as they enable you to quickly gain access to your money.

Why you need a cash flow reserve

A healthy cash flow reserve ensures you won’t run out of cash! In addition, a cash reserve is useful in several scenarios:

To provide money if needed right away for a large purchase.
To cover unexpected payments.
To pay your tax bill.
To cover lean periods: for example, if your customers are slow to pay you, or if your business is seasonal.

In addition, cash reserves for business can help you:

Further your future exporting or expansion plans: a cash reserve means you have the cash to support your plans.
Finance liquid investments to complement your cash reserve, as these investments can generate higher returns than leaving your cash in the bank.
Avoid high-interest-rate options such as credit cards or additional loan debt to finance short-term needs.

To sum up, what is cash reserve? Think of it as a short-term solution to a short-term issue, a buffer against the unforeseen and a slush fund to seize opportunities. Loans are better used to finance larger, planned expenditures such as capital expenditure.

Calculating the cash flow reserve ratio

The standard recommendation for cash reserves is to keep enough liquidity to cover between three and six months of operating expenses. Putting aside too little means you run the risk of running out of cash, while hoarding too much cash can be detrimental to your future business, as the money can usually be put to better use elsewhere. Our business liquidity calculator can help you make sense of it all.

Start by examining your expenses and earnings ‒ as well as your full-year cash flow statement. This analysis will also provide insight to your cash flow management.

The cash flow reserve ratio formula

Subtract total expenses from total revenues to see the total amount of money that went towards business expenses over a certain period of time (what’s left is your working capital). Then divide that figure by the number of months in the accounting period to determine your monthly cash burn rate:

Total revenues – Total Expenses / Number of months in accounting period = Monthly cash burn

To get the amount of liquidity you need for your business, multiply that number by the number of months you want your cash reserve to cover:

Monthly cash burn x Number of months of cover needed = Cash reserve required

Note that start-ups that don’t have financial statements yet can use the company’s cash flow forecast and business budget to establish the cash reserve amount.

Setting up cash reserves for business

Building up a cash reserve is crucial to running a successful business. Here are some ideas:

Scrutinise your cash flow. When the money’s rolling in, set some aside. Don’t overspend when there are lean months ahead.
Aim to funnel a certain amount each month into savings to boost your cash flow reserve.
Consider, in addition to cash, solid secure investments that generate higher returns than those paid by current or savings accounts.
Sell off your old stock in bulk to generate cash and lower your minimum stock levels by ordering stock only when you need it.

Safeguarding your cash flow is also important. Remember, it is at risk when customers are slow to pay or default. Consider trade credit insurance to cover late and non-payments that may impact your cash flow or force you to use your cash reserve. In addition, this solution can support your expansion plans. To learn more, get in touch.