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Small Business Finance Basics – What is a Reserve Fund and Should I Have One?

August 6, 2021

Most entrepreneurs open a business to follow a passion. Some are fortunate enough to have a background in managing finances, but many have very little or no experience handling business funds. Fortunately, accounting software makes this job less daunting, and if you employ a good bookkeeper or accountant, it requires even less “hands-on” time.

So, while you certainly don’t need an MBA in accounting to effectively manage your business, it’s essential to have enough financial knowledge to make smart spending decisions. Even if you offer outstanding products and services and your marketing and customer service are top-notch, your business can still struggle due to a lack of necessary cash flow. 

Below, we will explain some basic cash flow concepts to help business owners better grasp the financial aspects of running a business.

Cash flow, simply put, is incoming money from customers, minus the expenses of running a business (rent, insurance, payroll, equipment, supplies, etc.) over a period of time. When your income exceeds expenses, your business has a “positive cash flow,” and you should be able to pay off expenses.

Unfortunately, there may be times expenses exceed income – when you have large major expenditures, when customers don’t pay on time, or when there simply aren’t enough customers in the funnel. While the goal is to manage cash flow so situations like this don’t occur, there are simple mitigation strategies to utilize when they do. 

In positive cash-flow times, owners can get caught making overly-confident purchases. But just as we are taught to set money aside for the “rainy day fund” to cover unexpected personal expenses, businesses should follow the same philosophy. By regularly saving excess cash for a reserve or emergency fund, you will be much more capable of maintaining a positive cash flow month-to-month, even with occasional unexpected expenses. 

Business owners are often tempted to dip into these savings for various reasons, but reserve funds can be lifesavers for unexpected emergencies like broken air conditioners in the heat of summer, a blown transmission on a company car, or recently, the implications of a global pandemic. 

So, the golden question is: “How much should I set aside in a reserve fund for my business?” Experts recommend accumulating 3 – 6 months of expenses which can be difficult for small business owners, especially those just starting. Be persistent, consistent, and motivated to save – there is no right or wrong amount, but the more you can save, the better off you’ll be. 

Now, let’s look at the difference between a reserve fund and a sinking fund, and why your accountant may recommend both. Unlike a reserve fund for emergencies, a sinking fund is money set aside for large purchases that cannot be covered in a single month’s cash flow. 

Let’s say you need to purchase an item for your business that will cost $2,000, which exceeds your projected cash flow during a particular month. A sinking fund would allow you to save $200 per month over 10 months – thereby breaking up the expense, but also keeping a schedule of monthly “payments.” 

Keeping a close eye on cash flow and having a reserve and/or sinking fund to fall back on is  especially important for seasonal businesses. A martial arts school is a prime example of a seasonal business – the “summer blues” are well-known among school owners because this downtime can have serious repercussions on a business if not properly prepared for. 

Educating yourself on matters of small business finance is essential. Aside from savings, these practices can also help business owners understand tax liability and how to prevent fraud. Regular reports of income and spending help business owners avoid painful and costly surprises. 

Check out our Resources page for additional information on small business finance topics and follow us on Facebook to be notified about additions to our library for small business owners!