What factors impact your business cash reserves?

By Heather Bright, Partner

Counting your profit on paper as cash in the bank is like counting your eggs before they’ve hatched.

Profit might act as an initial promise, but cash is what can cover payroll, tax liabilities and supplier costs during periods of uncertainty.

Unexpected blows to cash flow can leave profitable businesses struggling to meet their obligations, which is why it is so important to keep some cash in reserve.

Business owners therefore shouldn’t ask whether they should have cash reserves, but rather how much is enough to offset unpredictability.

Why is cash (flow) king, not profit?

When liabilities can’t be paid for, the profitability of your business becomes peripheral.

Risks of insolvency can be mitigated by allocating cash for unforeseen expenses, like unpaid invoices, dips in consumer demand and equipment repairs.

Budgeting for a sudden change in circumstances is good practice, allowing funds to be accessed during crises or to capitalise on new opportunities without having to sell assets.

Failing to keep cash to one side may mean your business struggles to keep ticking over during rough patches, even if it is returning a profit on paper.

Why do businesses need bespoke cash reserves?

Annoyingly, as each business is different, there is no one-size-fits-all cash reserve figure that will serve as an effective buffer against unpredictability.

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

Revenue volatility

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

For example, a construction firm might complete a large project but then wait several weeks with no cash inflow, whereas businesses with rolling agreements and retainers can forecast when cash is due to hit accounts.

To assess volatility, you should look over the last two years, 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.

Client concentration and business cycles

If your business relies heavily on a handful of clients for a large share of revenue, losing one or two might lead to a cliff-edge drop in cash inflow.

In this case, cash reserves are needed to cover the time taken to recover the revenue from losing any 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 versus variable costs

With fixed costs leaving accounts regardless of revenue, the higher these expenses, the larger the reserves required.

If your costs are flexible depending on business activity, you may be able to reduce expenses quickly when revenue drops.

It is worth paying attention to the costs which can be scaled in response to revenue fluctuations, rather than just the total monthly business costs.

Evaluating whether a cost can be switched off within 30 days can help you calculate the cash reserve needed to cover your truly fixed expenses.

Credit facilities to absorb cash flow volatility

Cash reserves are not the only form of liquidity that can be relied upon in emergencies, as credit facilities can serve a similar purpose.

In some circumstances, overdrafts can be cheaper than setting aside profits, ensuring no cash is sitting idly in a bank account that could be generating higher returns invested elsewhere.

Invoice financing is also an option, with lenders advancing up to 95 per cent of an invoice’s total value almost immediately, instead of waiting 30 days or longer for payment.

However, 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.

Could a cash reserve be unnecessarily large?

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

With inflation steadily eating away at any cash that hasn’t been reinvested, your business can be passively losing money with reserves that are needlessly big.

The cash could have been used to maybe pay off a higher-interest debt or invested in equipment that could lower operating costs and make your 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 too big for your company to need, they might treat it as an ‘excepted asset’ that will be given the normal Inheritance Tax treatment.

However, cash reserves overall act as an insurance against uncertainty and it is unlikely for a business to fold because their emergency fund is too large.

Too large a cash reserve is undoubtedly a better problem to have than a business teetering on insolvency.

Consequently, cash reserves should be calculated by a specialist to ensure there are no pounds that could have been better spent elsewhere.

Speak to our specialists, optimise your cash reserves

Getting your cash reserve number right is important, so speaking to an accountant can help your business.

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.

Unsure whether your business could absorb an emergency? Reach out to our accountants for help creating your cash reserve cushion.