Running a small business and ensuring you always have cash on hand to pay your bills isn’t an easy task. Market volatility can take its toll on any type of business, especially when it’s still in the growing stages and trying to diversify revenue sources.
Saving money for a rainy day is a critical safety net for SMBs to survive when cash flow gets low. Delivery problems, a major customer, is leaving, or essential equipment breaking; whatever the reason, cash reserves keep businesses going when dealing with a drop in revenue or unexpected expenses.
While cash reserves reduce risk and help you avoid new lines of credit, they also tie up capital with little return. Businesses should always try to put their money to work, earning more money. Sitting cash limits new investment into the business, and they only make low-interest rates because they need to be available immediately when needed.
Finding a suitable cash reserve plan for your SMB takes significant thought and depends on different factors, such as:
- Receivables: how long is your typical payment collection period?
- Inventory: how much stock do you have to have on hand?
- Payroll: how many employees are on your payroll?
- Seasonality: does your revenue vary considerably throughout the year?
- Personal finances: do you have personal savings that you’re willing to use in an emergency?
Some argue that a good cash reserve target is at least three months of working capital. However, a survey from The Harris Poll found that 4 out of 10 SMBs don’t have enough cash in their bank account to last more than three months without seeking external help.
So how can you get on the right side of that stat and start building a healthy cash reserve for your business? Here are six tips and best practices to ensure your safety net is big enough to catch you if you fall.
1. Credit management
You can’t begin saving money for a cash reserve without proper procedures to get paid. Offering credit is a great way to grow your customer base, but it means adapting cash flow and invoicing processes to ensure each sale results in prompt payment.
Avoiding bad debtors and implementing effective credit management leads to a reliable source of income and which leads to more capital for your emergency fund. Things to consider:
- Late fees.
- Early payment incentives.
- Running credit checks to assess the risk of each customer.
- Fast and accurate invoicing.
- Offering multiple payment options.
- Asking for deposits or progress payments.
2. Debt management
Debt management is just as important as managing the money owed to you. You want to find the best terms that fit your company. This means balancing interest rates and settlement periods to ensure your monthly payments are manageable and you can continually set aside cash.
A good approach is to renegotiate your current debt to lower monthly repayments. If existing creditors are unwilling to change terms, you can try finding new ones with more flexible payment plans. Getting favorable terms may require good credit history.
Another approach is to clear all your debts as fast as possible so that funds can go straight into your cash reserve. This is only suitable for specific situations and businesses, as running a business without debt obligations is challenging.
3. Reduce expenses
The simplest way to free up cash for your emergency fund is by reducing expenses. Savings can usually be found even in what looks like a fixed budget. Slide any savings you see from your expenses into your cash reserve, and you’ll quickly be on the way to reducing future risk.
When trying to reduce your expenses, these are some excellent places to start:
- Favorable rates or terms by renegotiating supplier contracts, particularly if these are long-term partnerships.
- Improving productivity to reduce required resources or payroll.
- Shifting to lower-cost operating models, this could be a more direct-to-consumer or a wholly online sales approach.
- Downsizing premises if you can maintain output with less space.
- Finding lower-interest credit options and paying off existing high-interest debt (i.e., credit cards).
4. Liquidate unnecessary assets
Many companies have assets that are no longer critical for their operations and are just depreciating on their balance sheet. Whether it’s old machinery, vehicles, computing hardware, or any other unused asset, it’s usually better to liquidate them. Then you can put the capital to use for something more applicable to your current situation, like a cash reserve. A sudden cash inflow can be perfect for recovery after an unexpected expense or an ideal start for an emergency fund.
5. Create targets
While running a business, there are so many things to consider, and adding funds to your cash reserve every month can easily slip down your list of priorities. Often companies just see what they have left at the end of the month and add that to their reserve. This passive approach to saving money for a rainy day struggles to achieve the funds needed if the unthinkable happens in the future. It’s better to budget monthly cash reserve payments with set targets actively.
6. Pay back what you use
When you have to use your cash reserve, make sure to top it back up. See this as an interest-free debt you owe your business and therefore replenish the amount you took out. Additionally, it helps to keep your cash reserve separate from the rest of your finances because it shouldn’t constantly be used. Instead, use your working capital; that’s what it’s there for.
Fail to prepare, prepare to fail
Cash reserves are critical for covering costs during emergencies. When your budget goes out the window, you need emergency funds that can break your fall. While your cash reserve may currently be at the bottom of your priorities, adequate preparation and effective cash management make it possible to find monthly funds to store away for the future.
