When it comes to the health of your small business, cash is king. A staggering 82% of business failures trace back to cash flow problems, according to SCORE. Yet many factors leading to cash flow woes are out of your control, from slow-moving inventory to customer payment issues. This underscores the vital importance of cash reserves.
A healthy cash reserve can serve multiple purposes. Beyond acting as a financial safety net, it can be used to fund unexpected growth opportunities, helping you avoid taking on new debt. The ideal reserve amount will vary based on a few unique factors, including your liquidity ratio and your cash flow needs.
What is a cash reserve?
A cash reserve is like emergency savings for your business. Similar to a personal rainy day fund, it's money you put away to cover your debt obligations and business expenses—such as payroll, insurance and utilities—during difficult periods. Your cash reserve might include physical cash and any liquid assets your business holds.
What are liquid assets?
Liquid assets are any assets that can be quickly converted into cash. The easier it is to convert an asset into cash, the more liquid it is. While cash and cash equivalents like checking and savings accounts are the most obvious examples, your business likely has other types of liquid assets. These may include:
- Certificates of deposit, or CDs
- Accounts receivable, or what your customers owe you
- Marketable securities like stocks, bonds or mutual funds
- Your inventory on hand
Conversely, illiquid assets are any capital assets that would be difficult to quickly convert into cash. These might include:
- Buildings or land
- Machinery
- Private equity investments
- Fleet vehicles
Having a strong cash reserve is essential, but it's just as important to take a balanced approach. While a lack of cash can put your business at risk, holding too much in reserve might indicate that you're overlooking opportunities to reinvest in your business.
What is a healthy cash reserve?
Just like a personal emergency savings fund, the general rule of thumb for business cash reserves is to set aside 3 to 6 months' worth of operating expenses. Determine this figure by tallying the costs of running your business for a month—such as payroll, insurance and utilities, as well as debt obligations—and then multiplying. The previous year's cash flow statement can be a helpful starting point.
As part of this exercise, you may want to calculate your business's liquidity ratio. This can help you get a better handle on your company's financial health and predict how well you'd be able to sustain your business during lean periods.
How to calculate liquidity ratios
The three most common liquidity ratios are current ratio, quick ratio—also called acid test ratio—and cash ratio. Should any of these calculations yield an unfavorable ratio, it's a telltale sign that you need to focus on bolstering your cash reserves.
Current ratio
Because it uses information from your balance sheet, the current ratio is often the easiest to calculate. To calculate current ratio, divide your company's current assets by your current liabilities. A current ratio of 1 or more means your company has sufficient assets to pay off its liabilities. If the ratio falls below 1, your business may struggle to meet its current obligations.
Quick ratio
The quick ratio only looks at assets that can be turned into cash within 90 days. This includes cash, cash equivalents, accounts receivable and marketable securities—but not inventory. To calculate the quick ratio, start by adding up these assets, then divide that sum by your current liabilities. A quick ratio of 1 or more is considered very good, indicating your business should be able to meet its obligations with its current cash reserves.
Cash ratio
The cash ratio is the most conservative measure of liquidity because it only counts cash and cash equivalents. To calculate the cash ratio, divide the sum of your cash and cash equivalents by your business's current liabilities. A cash ratio of 1 or more indicates that your business could pay its debts using cash on hand. Any lower, and you could face challenges if your sales or receivables slow down.
Establishing a cash reserve account
Many small businesses keep their cash reserves in a business checking account. While it's important to keep enough money accessible for everyday expenses, moving idle funds into an interest-bearing account may be a smart move.
Types of business savings accounts
The most prudent business savings accounts are those that offer both interest and Federal Deposit Insurance Corporation, or FDIC, protection. Here are some of the most common cash reserve accounts.
Sweep account
Sweep accounts are interest-bearing holding accounts that grow by automatically transferring excess funds from your checking account. Once you establish a fixed daily balance, any surplus in your end-of-day balance gets swept into the sweep account.
Interest-bearing checking account
These accounts offer interest on a regular checking account balance, allowing for easy access to funds. Drawbacks may include higher fees and higher minimum balance requirements than standard business checking accounts.
Business savings account
A business savings account provides a safe place to stash your cash and earn interest. One common constraint is a limit on the number of withdrawals you can make per month.
Money market account
Money market accounts are high-interest savings accounts that include check-writing privileges. These shouldn't be confused with money market funds, which are a type of investment. Potential downsides to money market accounts include limited monthly transactions and higher minimum balance requirements.
CD account
CDs are a type of savings account where you agree to leave your money untouched for a stated period of time in exchange for a higher interest rate. Drawbacks may include minimum deposits and penalties for early withdrawals.
When opened through an FDIC-insured bank, funds deposited in these accounts will be insured up to $250,000. If your cash reserves exceed that amount, know that there are ways to maximize FDIC protection on business accounts.
The bottom line
Even consistently profitable businesses aren't immune to cash shortfalls, which highlights the importance of maintaining healthy cash reserves. As a rule of thumb, aim to set aside at least 3 to 6 months' worth of operating expenses. This financial cushion not only fortifies your business during lean periods but also primes you to seize growth opportunities as they arise.
