Why Small Businesses Need 3 Months of Operating Expenses in the Bank
Written by Bindi Gethen
Running a small business is a lot like walking a tightrope. It’s thrilling and rewarding, but also incredibly scary at times. One of the scariest parts? Finances. Having a decent cash reserve can be the difference between keeping your business afloat during tough times or going under.
And it’s not just about survival. That cash reserve also gives you the freedom to take calculated risks, seize unexpected opportunities, or invest in growth when the time is right. It’s not just a buffer – it’s a launchpad. It’s the foundation upon which you can build a successful, resilient business.
So how much should a small business have in the bank? The golden rule is to have at least three to six months’ worth of operating expenses stashed away in the bank. This allows your business to weather slow periods, unexpected costs, or sudden changes in the market.
How much should a small business have in the bank?
Businesses, big and small, often face unexpected downturns. This could be anything – a drop in sales, a major client pulling out, or even a global event like a pandemic. When these things happen, your regular income might take a hit, and that’s when your saved funds keep you afloat. When you have three to six months’ worth of operating expenses, you’ll be able to handle any emergency or downturn.
Operating expenses refer to costs such as rent, utilities, salaries, marketing expenses, and inventory costs. Let’s say, hypothetically, these sums up to $30,000 a month for your business. This indicates that you should keep around $90,000 in your bank as a safety net.
But this is just a baseline. Depending on the nature and risks associated with your specific business, you might require more. It’s always wise to consult with your financial advisors or accountant to tailor these numbers to your particular situation.
You might be thinking, “That’s a lot of money to just have sitting in the bank. Couldn’t I invest that capital back into my business or find a higher-return investment elsewhere?” While profitability is fantastic, it’s what will ultimately drive your business’s success in the long run.
Cash flow, the money available to you at any given moment, is what keeps the lights on day-to-day. It allows you to pay your bills, meet payroll, and handle any unexpected expenses that arise. It might be tempting to reinvest all your profits back into your business or chase higher returns elsewhere, but having a healthy amount of cash in the bank gives you the flexibility and stability to handle whatever comes your way.
How to determine how much cash your small business needs in reserve
1) Figure out your monthly expenses
Start by making a detailed list of your fixed expenses. These may include rent or mortgage payments, payroll, utilities, taxes, and any recurring loan payments. Don’t forget to factor in variable costs, such as materials, product inventory, marketing and advertising expenses, and unexpected bills.
Variable costs can get a bit tricky. Materials and product inventory can fluctuate significantly, especially if your business is seasonal or influenced by market trends. Marketing and advertising expenses might change depending on campaigns, and unexpected bills could arise from equipment failure or emergency repairs.
Try using an average of the past year’s costs for these categories, but remember, it’s essential to leave some room during your budgeting process for unexpected increases.
Example
Imagine you run a small coffee shop:
Monthly rent of $2,000
Payroll at $5,000
Utilities averaging around $500
Recurring loan payment is $1,000 per month
Taxes, based on last year’s rates, come to $6,000 annually or $500 per month
–
Total fixed costs: $9,000 per month
Average of $3,000 per month on coffee beans, milk, and other inventory
Marketing costs average out to $500 per month
$500 for potential equipment repairs or other unexpected costs
–
Variable costs: $4,000 per month
Adding both fixed and variable costs, your business has total monthly expenses of $13,000. Therefore, if you need to reserve enough cash for three months’ worth of expenses, you should ideally have $39,000 in your business reserve.
2) Look at the monthly cash flow projection
Look at your business’s cash inflows and outflows during a specific period. Forecasting should be realistic: Overestimate your expenses and underestimate your income.
For instance, if your small coffee shop generates an average revenue of $20,000 per month, your cash inflow is positive. After deducting your total monthly expenses of $13,000, you are left with a net cash flow of $7,000 per month.
Pro tip
Revenue may fluctuate. There may be quieter months with lower sales. That’s why you need to maintain an adequate cash reserve to tide over less profitable months and unexpected expenses.
3) Put aside enough cash to cover three to six months of operating expenses
This isn’t about hoarding every penny – it’s about striking a balance between caution and ambition.
There are instances when you might need to consider having more than six months of operating expenses in your cash reserve. If your business operates in a volatile market, or if you have plans for significant future investments, a larger safety net could be beneficial. A greater reserve offers the chance to navigate economic downturns, industry transformations, or unforeseen crises with a bit more ease.
Start small. Consider setting aside a percentage of your monthly net cash flow. Consistent saving, no matter how small, can accumulate significantly over time. Additionally, consider reinvesting profits back into the business to stimulate cash flow. You could also look into obtaining a business line of credit to handle short-term cash needs.
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4) Keep a separate business emergency fund
The business emergency fund is like a safety net, designed to cover unexpected costs or sudden downturns in revenue. This is your financial shock absorber. It’s the fund you dip into when the unexpected happens, like a critical piece of equipment breaking down or a sudden market shift.
On the other hand, operating expense reserves are basically cash set aside to cover your day-to-day operational costs. This includes everything from rent and utilities to employee salaries and supply costs. Operating expense reserves are there to ensure the smooth running of your business, enabling you to meet your financial obligations even during low-revenue periods.
Try to cut back on non-essential expenses and redirect that cash into your emergency fund.
Examples
Consider a restaurant business. A sudden hike in food prices could significantly impact their operating expenses. Having an adequate operating expense fund would allow them to absorb this change without disrupting service. If they use their emergency fund instead, they might find themselves in a bind if a piece of critical kitchen equipment like the oven breaks down or a larger crisis like a fire happens.
Now, think about a software development firm. The bulk of their operating expenses might be in payroll, given the high salaries that developers command. If a major client delays payment, having a reserve for operating expenses would enable them to meet payroll without affecting employee morale or productivity. If they dip into their emergency fund, they may not be able to handle an unexpected event like a server crash or a costly software licensing issue.
5) Analyse your choices for growth opportunities
When considering growth opportunities, it’s essential to examine these opportunities in terms of their potential rewards and their associated risks. Analyse the resources that these opportunities would require and the impact they might have on your cash reserves.
A growth opportunity might seem attractive on the surface, but if it would significantly deplete your operating expense reserves or even dip into your emergency fund, then it may not be a viable option.
Pro tip
Growth is not just about expansion; it's about sustainable expansion.
6) Stay on track
Start by establishing clear guidelines about what constitutes acceptable use for each type of fund. This clarity will deter the temptation to dip into emergency funds for routine operating expenses.
Review your reserve levels on a regular basis (monthly or quarterly). Also, don’t forget to replenish your reserves as soon as possible after they’ve been used. Remember, reserves are like safety nets. They’re only useful if they’re there when you need them.
Frequently Asked Questions
In the early stages, your business might be more vulnerable to fluctuations in income or unexpected costs. As your business matures, you may find your income streams become more predictable but your operating costs increase. It’s still up to you if the “three to six months rule for your cash reserve rule” applies.
In the Startup stage, cash reserves are crucial for addressing unexpected costs and sustaining operations as the business is yet to generate a steady income.
The Growth stage sees your business start to generate consistent income, but it’s also a period of significant investment in areas like marketing, hiring, and product development.
During the Maturity stage, your business has a steady cash flow and predictable expenses. Your cash reserve requirements may decrease, but it’s still crucial to a robust reserve for unforeseen circumstances.
Finally, in the Renewal or Decline stage, cash reserves become a lifeline. If the business is declining, reserves can fund restructuring or pivoting efforts. If it’s renewing, they can finance expansion strategies.
Business savings accounts can offer a secure place to store funds while also providing a small amount of interest. However, the accessibility of these funds may be somewhat limited.
Money market accounts, on the other hand, often offer a higher interest rate than traditional savings accounts, combined with the flexibility of a checking account. This means you can earn interest on your reserves while still having easy access to your funds.
A Certificate of Deposit (CD) locks in your money for a set term, but typically offers a higher interest rate in return. This can be a good option for funds you don’t anticipate needing in the short term.
Lastly, short-term investments, although involving some risk, can be profitable if managed wisely. Always remember to diversify your options and consult with a financial advisor to decide what works best for your specific needs.
As the adage goes, cash is king. Having more cash on hand can certainly provide your business with increased flexibility and stability. It allows for immediate responses to unexpected costs, opportunities for business growth, or short-term financial downturns.
However, it’s not without its caveats. Cash sitting idle in bank accounts isn’t working for your business. It’s not being invested in growth initiatives nor is it earning significant interest. In fact, with inflation, its value could be slowly eroding over time.
Striking a balance is crucial. This balance will vary depending on the nature of your business, the industry you’re in, and the financial climate. Again, this underscores the need for personalized financial advice.
For your business bank account, here are a few key factors to consider:
Fees and charges: Look for a bank that offers low or no monthly maintenance fees. Also, take note of transaction fees, cash deposit charges, ATM fees, and any other additional costs that may accrue over time.
Transaction limits: Some banks may place a limit on the number of transactions you can make each month. If you anticipate a high volume of transactions, seek a bank account that offers unlimited transactions.
Additional services: Some banks offer extra services such as payroll assistance, merchant services, and business credit cards. If these services align with your business needs, they could be a deciding factor.
Let’s make sure you save enough to weather the storms and downturns
It’s entirely possible to build your own savings strategy and many business owners do just that. But when we talk about managing finances, especially for growing businesses, it’s much more than just saving – it’s about strategic financial planning, mitigating financial risks, and driving business growth through financial insights.
Our virtual bookkeeping agency brings financial acumen to the table. We make your money work harder for your business. But don’t just take our word for it. Hundreds of small business owners across Australia have given their review about what it’s like working with us.
Start doing research on your next bookkeeping partner today.
Hey, my name’s Bindi Gethen! I’m the founder of The Bookkeeping Studio in Australia. With over 15 years of experience in the industry, I have a deep understanding of the challenges that small and medium-sized business owners face when it comes to managing their finances.
I am passionate about empowering my clients with the financial information they need to succeed. My team and I pride ourselves on our commitment to exceptional value, accuracy, and confidentiality. Our virtual bookkeeping services include payroll, budgets, and management reporting, among others.
Not to toot our own horn, but we can assure you that you won’t find a bookkeeping partner like us anywhere else in the Southern Highlands.
