Does a business need an emergency fund? Yes, it does. Unexpected financial problems can hit any company, particularly small businesses, and having cash reserves on hand might mean the difference between weathering a setback or closing up shop.
Today, I want to give you a brief overview of what a business emergency fund is, how to estimate the cash reserves your fund needs based on your business, what methods you can use to build a usable emergency fund, and additional measures you can take to avoid, or at the very least anticipate and soften, periods of financial strain.
An emergency fund is a reserve of liquid assets your business can use immediately to deal with unexpected financial hardship.
Examples include sudden losses of revenue or drastic increases in expenses necessary for normal business operations. The causes vary, ranging from macroeconomic disruptions to the incapacitation of a key partner.
“Key partner” could be the individual responsible for client and vendor relationships and contracts. Soon, invoices are not being paid, and vendors are nowhere to be found. He might, alternatively, be the linchpin of operations, his incapacitation crippling the productive capacity of the business.
Do not anticipate leniency from vendors, suppliers, banks, or employees.
- Rent or mortgage payments
- Payments to vendors for inventory or materials
- Payroll expenses
- Debt repayments
Debts must be paid. Revenue is not flowing in. Normal expenses continue to flow out.
For sole proprietors and even limited liability companies (LLCs), emergency funds may be necessary to protect personal assets from exposure to business liabilities.
Let’s say you’ve taken out a business loan. You may have signed a personal guarantee. Alternatively, you may have backed the loan by using business assets as collateral. Either way, you’re personally liable if your business defaults on the loan.
In this nightmare scenario, the lender may argue that your corporation and its liabilities are actually yours and convince the court that your assets are fair game. The purpose of having an emergency fund is to prevent the situation from escalating to the point of seizure of one’s home, vehicles, property, and possessions.
Start an emergency fund that covers at least three months of operating expenses.
That’s a safe amount that strikes a balance between caution and flexibility. To increase your security, consider saving up to six months of operating expenses.
Build your fund over time. It’s not worth crippling cash flow.
Build up your cash reserves fund over time. Try to contribute 10 percent of your monthly revenue toward it. If that’s not achievable, start smaller and work your way up.
How do you calculate the liquidity you need for three months’ expenses?
Start by estimating your total monthly expenses, including fixed costs like rent and payroll. Then add your variable costs like utilities.
Once you have your monthly figure, multiply it by three; that number is the minimum amount of liquidity you need on hand to maintain operations for three months without additional revenue.
Use retained earnings to build your emergency fund.
Retained earnings, also called cash reserves or capital reserves, are profits that your business keeps instead of paying out to owners or shareholders.
The easiest way to build your emergency fund is by setting aside a portion of your retained earnings. Put this money in a separate savings account so your emergency fund grows over time, or simply maintain a designated amount that remains stable every month after expenses.
Consider moving emergency funds into a high-yield savings account.
To maximize the value of your retained earnings, consider storing your emergency fund in a high-yield savings account. It’ll offer better interest rates than traditional business savings accounts, so your emergency fund can continue to grow. But be sure the account is FDIC-insured and allows quick withdrawals, so you can access your money if there is an emergency.
Make payments automatic and negotiable only by agreement among partners.
That way, your emergency fund grows predictably, and you and your partners are not tempted to dip into the fund for new initiatives unless those opportunities are worth the risk and all parties agree.
Another option is a credit-based emergency fund.
With a credit-based emergency fund, you rely on a pre-approved business line of credit rather than setting aside profits. It offers immediate access to funds and a degree of flexibility.
I don’t recommend this option. A credit-based fund comes with interest charges. And if you’re unable to repay your loan, you can build up debt, putting you further in the hole.
Can forecasting avert the unexpected? Perhaps not, but it can soften the blow.
Most emergencies will be unexpected and impossible to predict. What we want to avoid is predictable slumps compounding the effects of catastrophes.
If your business is seasonal — for example, you have a tree care company — you should have a solid understanding of how much you expect revenue to decrease in the winter months. That way, you might choose to put away more during revenue-producing seasons in order to stay financially prepared.
Similarly, if you start to see a convergence of factors—souring relationships, economic troubles, and even litigation—consider the effect on your business if you were to invest a bit more than normal into your emergency fund.
Yes, an on-demand CFO can help.
The key to making an emergency fund work is robust forecasting. An on-demand CFO with expertise in forecasting can make sure your business is tracking trends and anticipating fluctuations, so your business will have the right amount of cash reserves.
Let’s get into the numbers and find a workable number for your emergency fund.
We’ll start with your financial statements, debt, and relationships with vendors and clients. We don’t want to think about a future scenario where we lose a partner or get caught in market forces, but now is exactly the time to have those conversations and put together a plan.
Schedule a discovery call today to get started.
Talk soon,
Jeremy A. Johnson, CPA