Sudden drops in cash inflow can leave businesses struggling to meet obligations, even if they appear profitable on paper.

Profit might act as a promise, but cash in the bank is what can actually cover payroll, tax liabilities and supplier costs during periods of downturn.

To solve this problem, businesses can set some cash aside to ensure gaps in working capital can be bridged when needed.

Therefore, the question isn’t whether your business should have emergency funds, but how much is enough?

Why do cash reserves differ from business to business?

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

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

Unpredictable revenue

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

For instance, a manufacturing company may complete a large project but then wait several weeks with no cash inflow, whereas businesses with a subscription-based agreement can forecast when cash is due 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.

Concentrated client base

If your business relies heavily on a small client base for a large share of revenue, losing a few could lead to a drastic drop in business revenue.

In this case, cash reserves are needed to cover the time taken 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 to cover them.

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

Instead of focusing on the total monthly costs of a business, you should pay attention to those which can be quickly downscaled in response to falling revenue.

Evaluating which costs can be cut off within 30 days can help you calculate how large your cash reserves need to be.

Access to alternative capital

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.

Sometimes, 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.

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

Relying on credit leaves you vulnerable to higher borrowing costs or facilities being reduced or totally withdrawn.

Hidden costs of un-optimised cash reserves

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

With inflation steadily eroding uninvested cash, your business can be passively losing money with reserves that are larger than they need to be.

Excess cash could have been used to cover a higher-interest debt or to invest in industrial plant that could lower operating costs and make a business more efficient.

Moreover, 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 unrealistic for your commercial needs, they might treat it as an ‘excepted asset,’ which will be given the normal Inheritance Tax treatment.

Overall, cash reserves act as an insurance against uncertainty and it is unlikely for a business to collapse because its emergency fund is too large.

Too much money in the bank is a better problem to have than insolvency.

We encourage SMEs to speak to a professional to ensure their cash reserves are optimised and that there are no pounds that could have been better spent elsewhere.

Speak to an accountant

We can forecast your cash flow and fixed costs to determine how large your buffer needs to be, while freeing up any cash that 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.

Optimising your cash reserves is important. Reach out to our accountants.

Unsure how to calculate your cash reserves? Speak to our accountants for guidance on protecting your business from uncertainty.