What it means
A liquidity buffer helps a business pay bills when cash inflows slow or unexpected costs arrive, and it might be held as bank cash or highly accessible resources. Its purpose is resilience, not maximising investment return, so a business should know which funds it can use today and which are tied up.
The US Small Business Administration and FDIC provide cash-management guidance for small businesses, while the Bank for International Settlements describes a formal liquidity coverage ratio for banks that is not a target for an ordinary trading company. Start with a cash-flow forecast by week, or by day for a tight situation, listing customer receipts at realistic dates and payables when they are due.
A company can be profitable and still miss payroll if cash arrives after wages are due. Then stress-test a few plausible shocks, such as the largest customer paying six weeks late, a supplier asking for cash on delivery or a machine failing, and estimate the cumulative cash shortfall rather than merely lost revenue.
Do not count every current asset at face value. Inventory may take months to sell, a receivable may be disputed, and a marketable security can fall in value or take time to liquidate, so apply a cautious availability test.
A committed credit line can supplement cash, subject to its conditions and remaining headroom, whereas an uncommitted overdraft can be withdrawn or restricted. Check covenants and security, especially under the stress scenario, because a "$2 million facility" does not help if it is fully drawn or unavailable after a covenant breach.
Separate restricted cash as well: a deposit pledged to a bank, customer funds held for another party or tax money reserved for imminent payment may not be freely usable. Label these balances in the cash report, since counting them twice can make the business appear safer than it is.
Size can be expressed in days of essential cash outflow. If readily available cash is $600,000 and essential daily payments average $20,000, simple coverage is 30 days, though this ignores lump-sum due dates and uncertain receipts.
A detailed forecast may show a tax payment that consumes much of the reserve tomorrow, and if one customer supplies half of receipts, a delay from that buyer can exceed a generic one-month reserve. Set a minimum floor and a replenishment plan, so that management knows which spending stops and who approves use when cash falls below it.
Rebuild the reserve after a shock rather than treating it as spare cash, and review it when the business changes, for example through a new warehouse, an acquisition, longer customer terms or a credit line expiring next quarter. A liquidity plan should also name who can authorise emergency transfers and a backup person, and bank access should be checked before a crisis, not when a payment is due.
In practice
Real-world examples.
Example
A wholesaler holds accessible cash for payroll while a large customer's payment is delayed. The finance manager checks the weekly forecast and confirms wages and key suppliers can be paid for six weeks. Nothing needs to be borrowed in a hurry.
Example
An undrawn committed facility supplements cash after its conditions and remaining headroom are checked. The treasurer confirms that no covenant would be breached under the stress case. The facility is treated as backup, not as a replacement for the cash reserve.
Example
A seasonal firm increases its reserve ahead of a quiet sales period and supplier payments. It sets a minimum floor and a plan to rebuild after the season. The owner knows in advance which spending would pause if the floor were reached.
Formula
Calculation
Illustrative simple coverage days = Readily available cash / Average essential daily cash outflow.
Worked example: $600,000 cash / $20,000 daily outflow = 30 days. If $100,000 of that cash is pledged to a bank and cannot be used, available cash is $500,000 and coverage falls to $500,000 / $20,000 = 25 days. A due-date cash forecast is more useful when payments are uneven, and credit lines should be assessed separately.Case study
Seen in the real world.
This illustrative and entirely fictional case follows Willow Catering, an invented firm whose largest customer sometimes pays late. It builds a weekly cash forecast and holds a reserve for payroll and critical suppliers while testing a six-week delay. It also checks when an overdraft can be drawn. The case does not declare a universal number of months of cash.
Willow then separates a pledged deposit from freely available cash in its monthly report and writes a one-page response plan. The plan names who approves spending when cash falls below the floor and who can authorise transfers if the owner is away. The firm reviews the plan whenever a new contract changes its payment terms.
Watch out
Common mistakes.
- Counting stock or a disputed receivable as immediately spendable cash.
- Using average monthly costs without testing when payroll, tax and loan payments actually fall due.
- Assuming an uncommitted credit line will always be available during a stress event.
Questions
People also ask.
What is a liquidity buffer?
A reserve of reliably available resources to cover cash needs during a shock or shortfall.
How big should it be?
Forecast payment timing and stress-test plausible shocks. There is no universal number of months.
What counts toward it?
Accessible cash and, where conditions permit, undrawn committed facilities; do not equate inventory with cash.
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