One of the things many of you ask me during our meetings is how to build financial reserves in your small business. Well, first of all, your business should be making profit. You cannot build reserves if your business is not profitable. If your business is not profitable, you need to address that problem first.
What are financial reserves?
A financial reserve is money that you keep separate and do not use for daily business operations. Consider it savings, even if the money is not kept in a savings account.
- Money that is built up in your business that you do not take out of the business
- A certain amount of money that in your (business) savings account and that you do not touch except in certain circumstances
Why is it important to have financial reserves?
Having a financial reserve means that your business is prepared for the future and prepared to deal with unexpected situations. Financial reserves give you freedom:
- If you have a seasonal business, you can use financial reserves to keep your business running when customers don’t buy. It can help you run the business and pay bills when money is not coming in.
- Financial reserves can be used to invest in your business without having to depend on other people or funders. For example, it becomes possible for you to introduce new products or services. Adding products and services that have a higher profit can help to grow your business faster.
- It means that there is money available for you to do additional marketing when you see customer demand increase. It gives you the opportunity to build your brand and reach more customers.
- It means you have money that you can use to take advantage of business opportunities. This could be buying additional stock at cheaper prices and being ready to serve the market for a longer time. Or maybe there is a new business venture that you have been wanting to start. Having financial reserves makes it possible for you to do so.
- You can use financial reserves to deal with an emergency, whether business, personal or family.
- Having financial reserves gives you peace of mind.
What size should your financial reserve be?
This depends on what your expenses are.
1 How much are the expenses that you need to cover?
If you do not know, follow this link to learn how to find out. Take note of the amount you spend per month on business expenses and the amount you spend on personal and family expenses. Determine which amount to save.
Your assumption should be that you will not receive any sales during the time you will be taking money from your financial reserves. If you have a spouse or partner who is also bringing in money, you may be able to cut costs and live on the one income. In this case, your financial reserve will only need to cover your business expenses.
2 What will the financial reserve be used for?
Are the financial reserves intended to only cover the business expenses or also your personal and family expenses? If the financial reserves are intended to only cover your business expenses, the amount you need to keep as a reserve will be less.
3 How long should the financial reserves last?
The recommendation is to have at least 3 months of expenses in savings. However, it is better to have at least 6 months. The reason for this is that having 3 months will allow you to deal with an emergency. While having 6 months will allow you to develop new business or even learn the skills to find a job if necessary.
For small businesses, it is actually recommended to have 12 months of living and business expenses. Note: it may take time to reach this amount. Start small. Focus on building up reserves to carry you for 1 week, then 2 weeks, then 1 month, then 3 months, then 6 months, before focusing on 12 months.
4 Should the financial reserves cover 100% of your expenses?
If you want your reserves to cover 100% of your expenses, then obviously the amount you need to have in reserve will be higher than if it has to cover 50%. If you have a partner who is also bringing in money, you may decide to reduce the amount that your reserves have to cover. Or, you can still save 100% but use it to carry you twice as far.
Based on this, you will now be able to determine what amount you need to build up in your reserve.
How to build financial reserves in your small business
First of all, have a separate savings account if possible. This will help you to not touch the money. Or if you have strong discipline, agree with yourself that there should always be a certain amount in your bank account that you will not touch.
You can also save cash at the business or at home, but this may be a risk because of theft. Also, keeping money at home may increase the temptation to use it anytime you are short on cash.
Once you have determined the size your financial reserve, the question becomes how to build it up. This depends on various things, like how much money your business is making. This will determine how long it will take you to build up the reserve.
There are various ways to build up financial reserves. You can choose one or more of the following:
- Pay yourself first. Anytime you take money from the business for personal use (or if you pay yourself a salary), add 5 – 10% of that amount to your reserve.
- Consider the building up to be a monthly business expense. Like your electricity bill or rent. Every month, transfer a certain amount to your savings account to add to the reserve.
- Save 2 – 10% of all sales every week or every month. Whenever you calculate your sales for the week or the month, take a small percentage to add to your reserve. So, if you are saving 2%, and your weekly sales equal €100, you will take €2. If you are saving 10%, you will add €20 to your reserve.
- Save 5 – 10% of your net profits every week or every month. After you calculate your net profit, set a small percentage aside and transfer this money to your savings account.
- Find a way to generate additional income and save 50 – 100% of that income. If a family member can take on some work, let them do so and save that income also.
- Reduce costs as much as possible. Then add any money you manage save to your financial reserves.
- If you receive a gift of money from somebody, for example for your birthday, save 50% or even 100% of that amount to build up your reserve.
- After you repay a loan, keep saving the money you used to do repayments. But now, add those amounts to your financial reserve.
The most important thing about saving money to build up a financial reserve is to make it a habit. At the very least, try to save a small amount every month. Whether the amount changes per month is not important. It is the discipline of saving that will allow you to build your reserve.
When to use financial reserves
Make sure to have rules for yourself as to when you are allowed to use the money from your financial reserves.
- Before using your reserve, try to stretch your operational funds. For example, by negotiating terms with suppliers to ease their terms of payment. If you have a bank loan that you use for working capital, use that amount first. Keep the financial reserve as a last resort.
For example, you should not use the financial reserves for small repairs because you forgot to go the bank to get money. Or because your customer is late with payment.
- Give less credit to customers so that you have cash coming in to run the business.
- If you feel that you need to take money from your financial reserves, you should first look for ways to cut costs. Understand your non-negotiable expenses, like rent or business contract agreements. These are the expenses that you have to pay whether money is coming in or not. After that, look at the negotiable costs, like reduction of inventory size. Or making use of a cheaper kind of transportation.
Note: every business has unexpected expenses. It is possible to use your financial reserves to cover these expenses, but it is not recommended. It is therefore a good idea to have 2 savings accounts. One of them is for financial reserves that you only use in case of emergency. The second is a business savings account. This second account is used to cover any unexpected expenses. It can also be used to take advantage of business opportunities.
How to maintain financial reserves
Don’t forget to rebuild your financial reserves any time you take money out. Any time you use money from your reserves, focus on rebuilding it until it has reached the level that you want.