What it means
Income is uncertain and expenses arrive without warning. A machine breaks, a customer fails, a season disappoints, a tax bill is larger than expected, a lawsuit lands.
A business with a cash reserve absorbs these events and carries on; one without them borrows in a hurry, delays payments, sells assets at bad prices or, at the extreme, fails. The reserve is insurance the business provides for itself.
Setting the reserve starts with the business's exposure. The fixed costs that must be paid regardless of income (payroll, rent, loan service) define the monthly outflow the reserve must cover; the volatility of income and the concentration of customers define how long it might need to cover them; and the availability of other sources (committed facilities, owner support, insurance) reduces what must be held in cash.
Common policies are three to six months of fixed costs for small businesses, one to three months plus facilities for larger ones, and, for charities, three to six months of expenditure held as free reserves. The policy is written down, approved by the board or owners, and reviewed annually.
The reserve is held separately for three reasons. Segregation makes it visible and stops it being spent by default as part of the operating balance.
Safety and liquidity matter: the reserve must be there when needed, so it goes into instant-access deposits, money market funds or short-dated government securities, not into equities or long-term deposits. And the separation supports a rule for its use: the reserve is drawn only for the purposes the policy defines, with approval, and is rebuilt on a defined schedule.
Rules for use prevent the two failure modes: never touching the reserve because it has become sacred (so that the business borrows expensively while holding cash), and treating it as an overflow account (so that it is gone when the emergency comes). A typical policy allows drawing for defined shocks (loss of a major customer, an uninsured event, a facility withdrawal) and for defined opportunities (an acquisition or asset purchase at a discount), requires board approval, and requires rebuilding within twelve months from retained profits before any distribution.
The cost of the reserve is the return forgone: money on deposit at 3% in a business earning 15% on its capital costs 12% a year of the reserve's value. Against that, the cost of running short includes penalty interest, lost supplier discounts, distressed sales, damaged credit, and the possibility of failure.
For most businesses the reserve is cheap insurance, and the businesses that survived recent downturns with the least damage were, consistently, those that held one. Charities and public bodies formalise reserves through policies that funders and regulators expect to see.
Companies disclose reserves less formally, but lenders and rating agencies read the cash balance, the facilities and the stated liquidity policy together.
In practice
Real-world examples.
Example
A charity holds free reserves of four months of expenditure, disclosed in its annual report with its reserves policy, as its regulator expects.
Example
A restaurant group keeps two months of costs in a reserve account and used it fully during a period of enforced closure, rebuilding it over the following two years.
Example
A public company holds $500 million of cash against a $1 billion committed facility and describes its liquidity policy in its annual report.
Think of it
“Cash reserves are like your emergency savings-money set aside for unexpected needs or opportunities.
Formula
Calculation
Target Cash Reserve = Monthly fixed costs x Months of cover (policy) or Largest plausible shock + Margin
Months of Cover = Cash reserve / Monthly fixed costs
Cost of Holding the Reserve = Reserve x (Return on capital minus Deposit rate)
Rebuild rate = (Target reserve minus Current reserve) / Rebuild period in months
Worked example. A regional engineering consultancy with 45 staff sets its cash reserve policy.
Fixed monthly costs: salaries and on-costs $380,000; rent, insurance and utilities $45,000; software and subscriptions $20,000; loan service $15,000. Total $460,000.
Exposure analysis: revenue of $7,200,000 a year comes from about 30 clients, the largest at 18%; fees are billed monthly and collected in about 50 days; the business has no committed facility, only an overdraft of $150,000 that the bank can withdraw. Plausible shocks: the largest client stops work at short notice (loses $108,000 a month of revenue, with staff retained for at least three months while replacement work is won: cost about $325,000); a professional negligence claim excess of $100,000; a three-month general slowdown of 25% ($450,000 of revenue lost, costs cut by perhaps $100,000).
Policy chosen: reserve equal to three months of fixed costs, $1,380,000, which covers the largest single shock with margin and the combined shock of the largest client plus a slowdown ($775,000) comfortably. The overdraft is not counted, because it is uncommitted.
Current position: cash $820,000, all in the current account, with no separation. The reserve is under target by $560,000. Rebuild plan: $50,000 a month transferred to a separate money market account from monthly cash flow, reaching target in about eleven months, with the partners' quarterly drawings reduced by $40,000 a quarter to fund it. Operating cash is held at a minimum of $250,000 in the current account.
Cost: $1,380,000 at 3.5% in the money market fund earns $48,300; the partners estimate their return on capital in the business at 20%, so the opportunity cost is about $228,000 a year. They accept it: the firm's failure mode is a missed payroll for 45 professionals whose departure would end the business.
Rules: the reserve may be drawn for a defined shock or an acquisition, with the agreement of all partners; any drawing is rebuilt within twelve months before drawings resume at the previous level; the policy and the reserve's adequacy are reviewed each year against the updated cost base.
Test, eighteen months later: the largest client, under new ownership, ends its engagement with one month's notice. The reserve covers three months of the shortfall while two replacement clients are won; $340,000 is drawn and rebuilt over the following ten months. No staff are lost, no borrowing is needed, and the bank, told the position, extends the overdraft anyway on the strength of the reserve policy.Case study
Seen in the real world.
A specialist printing company had for years distributed all its profit to its two owners and kept cash at the minimum, relying on an overdraft for peaks. When its main press failed catastrophically, the repair quote was $180,000 with a six-week lead time, and the overdraft was already at its limit for the seasonal peak. The company borrowed the $180,000 from an asset finance company at 14%, missed a major order because the press was down, and lost the client.
The owners calculated that the episode had cost about $260,000 in financing, lost margin and the client's future work. They set a reserve policy: three months of fixed costs, about $400,000, held in a separate account, funded by retaining a third of profits until the target was reached and thereafter by retaining whatever was needed to maintain it. It took two years.
In the third year a competitor went into administration and its press, worth $350,000, was offered by the administrator for $140,000 for immediate cash purchase; the company bought it from the reserve, doubled its capacity, and rebuilt the reserve over the following year. The owners' note to their accountant said that the reserve had first been insurance and then been an opportunity fund, and that both uses had paid for it several times over.
Watch out
Common mistakes.
- Holding the reserve in the operating account, where it is spent by default and its absence is discovered in the crisis.
- Counting an uncommitted overdraft as the reserve. A facility the bank can withdraw is not a reserve; it is most likely to be withdrawn when most needed.
- Never using the reserve, so that the business borrows expensively or misses opportunities while holding cash, or using it for routine shortfalls so that it is empty when the shock comes.
Questions
People also ask.
How much should a cash reserve be?
Enough to cover the largest plausible shock with a margin, commonly three to six months of fixed costs for a small business, adjusted for income volatility, customer concentration and committed facilities.
Where should the reserve be held?
Somewhere safe, liquid and separate: an instant-access deposit, a money market fund, or short-dated government securities, in the business's own name and not pledged.
What is the difference between a cash reserve and retained earnings?
Retained earnings are an accounting figure, the cumulative profit kept in the business, which may be invested in stock, equipment or receivables. A cash reserve is actual money set aside. A company can have large retained earnings and no cash reserve.
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