How much cash should your business keep in reserve?

To count your profit on paper as cash in the bank is to count your eggs before they’ve hatched.

Profit might act as a promise, but cash reserves are what can cover payroll, tax liabilities and supplier costs during periods of uncertainty.

Shocks to cash flow can leave profitable businesses struggling to meet their obligations, which is why it is so important to keep some cash to one side.

The question therefore isn’t should your business have emergency funds, but how much is enough?

Why might cash reserves matter more than profit?

When obligations can’t be met, then the profitability of your business becomes irrelevant.

This is why businesses often allocate cash for unexpected expenses, such as customer insolvencies, unpaid invoices or sudden dips in revenue.

Doing so is good practice, as funds can be accessed quickly during emergencies or to take advantage of opportunities without assets having to be sold.

Without cash reserves, your business might struggle to keep operations ticking over during tough times, even if profit is being made.

Why is there no magic number?

Unfortunately, there is no one size fits all cash reserve that can protect your business from unforeseen circumstances.

The factors that can push your cash reserve figure upwards or downwards are:

Revenue volatility

Businesses with steady and recurring business models often need less cash reserves than those with seasonal or project based income.

For example, a construction firm might complete a large project but then wait several weeks with no cash inflow, whereas businesses with rolling agreements can forecast when cash is likely to reach accounts.

You should look over the last two years and identify your worst months and ask yourself the question: could you have covered your fixed costs wholly from your reserves?

If the answer is no, you might want to increase your cash reserve target.

Client concentration

If your business relies heavily on a handful of clients for a large share of income, losing one or two might lead to a cliff edge drop in business revenue.

Here, cash reserves are needed to cover the period needed to recover the revenue of losing important client contracts.

A concentrated client base and longer sales cycle will require a substantially higher cash cushion than businesses with hundreds of customers and quick turnover.

Fixed and variable costs

With fixed costs continuing regardless of revenue, the higher these costs, the larger the reserves required.

If your costs change with activity, you may be able to reduce business expenses quickly when revenue falls.

You should not pay attention to the total monthly costs of your business, rather those which cannot be promptly scaled down in response to falling revenue.

Determining which costs can be cut off within 30 days can help you calculate the expenses your cash reserve needs to cover.

Access to other backup funding

Business cash reserves are not the only form of liquidity that may be accessed in emergencies, as finance agreements or overdrafts can serve a similar purpose.

In some circumstances, overdrafts can be cheaper than setting aside profits, ensuring no cash is sitting idly in a bank account that could otherwise be reinvested for growth.

However, you should treat borrowing as a supplement and not a replacement for cash reserves.

Relying on credit to leaves you vulnerable to higher borrowing costs or facilities being reduced or totally withdrawn.

Is there such thing as too large cash reserves?

Leaving cash sitting in a bank account carries with it an ‘opportunity cost.’

With inflation steadily eating away at cash that hasn’t been reinvested, your business can be passively losing money with reserves that are too large.

This cash could have been used to pay off a higher-interest debt or invest in equipment that could lower operating costs or make your business more efficient.

In addition, money that is not actively being used for trading may sit outside of Business Property Relief (BPR).

If HMRC believes that the cash reserve is too big for your company to need, they might treat it as an ‘excepted asset’ that will be given the normal Inheritance Tax treatment.

However, cash reserves overall act as an insurance against uncertainty and it is unlikely for a business to fold because their emergency fund is too large.

Too big a cash reserve is a better problem to have than insolvency.

Cash reserves should be optimised and expertly calculated to ensure there are no pounds that could have been better spent elsewhere.

Let an accountant optimise your cash reserves

Getting your cash reserve number right is important, so speaking to an accountant can help your business get it right.

We can forecast your cash flow and fixed costs to determine how large your buffer needs to be, while free up any cash which is already tied up within the business.

Our experts can advise on how reserves might coincide with BPR and tax, offering suggestions on whether borrowing might be beneficial or the cash should be invested elsewhere.

Struggling to calculate your cash reserve number? Speak to our accountants today to create a cushion that helps protect against risks to your business.