A business must have enough working capital to pay off short-term liabilities and meet day-to-day expenses. Net working capital accounts for liquid assets, such as accounts receivables, inventories, cash, and cash equivalents. However, what happens when your debtors pile up, you need money to grow your business, and the sales fall? Depending solely on working capital and other liquid assets can be problematic in such situations. So it’s always a good idea for businesses to have some cash reserves set aside to meet short-term obligations and any emergency funding needs.
But what are cash reserves, the common types, and how can a business calculate them? Let’s find out.
Cash reserves: Meaning
Cash reserves refer to the money a business or individual saves to fund any unexpected or unplanned short-term expenses.
Cash reserves need not necessarily be cold, hard cash.
Short-term investments, such as money market instruments and treasury bills that can be liquidated instantly, usually at a lower rate of return, also form an important part of a business’s cash reserves.
Cash equivalents are also highly liquid investment vehicles and can be converted to cash easily. In a way, they are a business’s cash reserves in the balance sheet.
Although cash reserves make it difficult for a business to take advantage of investment opportunities and the return on investment is also low, a well-managed cash reserve can help a company scale rapidly, purchase new equipment, and meet any other unexpected expenses head-on.
Businesses usually open a dedicated business bank account to save money and build their cash reserves. This gives businesses immediate access to funds in emergency situations without incurring debt.
Cash reserves are not just maintained by businesses but also by banks. Banks must maintain a set percentage of their total deposits as liquid cash, known as cash reserve ratio, to operate risk-free.
Cash reserves: How much should you have?
A business should have enough emergency funds set aside to meet all short-term obligations for at least the next three to six months.
The amount will differ based on your business model and financial requirements, but this will help ensure you don’t run out of money when you need it the most.
How to calculate cash reserves?
Determining a cash reserve amount is a crucial business decision.
If a company settles on an amount that is significantly less than what it would need to cover any unwarranted expenses, it can leave the company in a vulnerable financial position when it needs funds the most.
On the other hand, if a company picks a number that is over and above what it would need to shoulder short-term expenses, it will be difficult for the company to invest its reserves to grow the business exponentially.
So a company must review its financial statements to ascertain the cash reserves amount. Generally, businesses use the previous year’s balance sheet or cash flow statement to find out its cash inflow and the amount it spent towards business expenses.
Dividing the amount of the total expenses by the number of months in the accounting period can help discover the monthly cash requirements of the business.
Multiplying this number by the number of months you’d like to build the cash reserve for should assist you in determining your business’s cash reserve amount.
Cash reserves: Example
Company AGP sets funds aside to cover its expenses for 3 months every year and wants to determine its cash reserves amount for the current financial year. It uses the previous year’s cash flow statement to arrive at a suitable number.
AGP’s total revenue and expenses for the previous year were £2,00,000 and £1,20,000, respectively.
So its monthly cash burn rate would be: £1,20,000/12 = £10,000.
This indicates that AGP must set aside at least £30,000 (£10,000 * 3) if it’s projecting similar revenue for the current year and wants to maintain cash reserves to cover the expenses for 3 months.
AGP’s cash reserves might go up if it decides to set aside funds for capital cash reserves or account for more months when allocating funds to operating cash reserves.
What are the two types of cash reserves?
Generally, there are three types of cash reserves, namely capital, operating, and debt-related. However, capital and operating are the two main types of cash reserves.
Operating cash reserves are built to address shortfalls in the monthly operating expenses. Such reserves can also help:
- Absorb revenue losses if the annual sales are less than the forecasted number.
- Tide the company over when there’s a significant timing difference between cash inflows and outflows. Such reserves can be used to address working capital requirements until the revenue is collected.
- Finance unexpected operating expenses. For instance, unanticipated machinery failure can catch a business off-guard, but operating cash reserves can help pay for the repair or replacement of the machine.
Capital cash reserves help pay for capital finance policies. Generally, money is set aside to finance the entire or a set portion of a future capital undertaking, such as the replacement of a long-term asset like a plant and machinery.
Such reserves are also used to:
- Finance unanticipated or extraordinary capital repair and replacement programs without spending time to secure capital.
- To pay for regular capital repair and replacement programs. Although they’re recurring, the cost may vary yearly, so capital reserves are usually built to accommodate higher-than-planned costs.
Conclusion on cash reserves
Cash reserves make it easy for a firm to meet any sudden operating or capital expenses. It empowers companies to take control of any unwarranted costs, letting them focus on leveraging business opportunities and improving the bottom line.
