While you’re investing in your bakery’s growth, you also need to plan for emergencies. Situations like equipment malfunction, a natural disaster or even lockdown implementations are often unpredictable, so without cash reserves, your business operations may suffer.
If you’re wondering how much cash reserves should be in your account, this article is for you. I will elaborate why you need spare funds for the rainy days and how to calculate it.
What are cash reserves?
Cash reserves refer to the money you set aside for emergencies, which can be used for disasters, economic recessions, equipment repair, debt repayment, and so on. Its purpose is for short-term capital needs that you won’t normally spend on a recurring basis.
Cash reserves are not limited to the money you physically have on-hand. They may take the form of bank account balances, cryptocurrencies, and other assets that you can liquidate to cash within 90 days.
Take note that you need to have immediate access to your cash reserves, so you won’t have a hard time using the funds for unforeseen circumstances.
How do cash reserves work?
Cash reserves could mean and work differently if you are a business entity, a banking institution, or a private individual. For a bit of context, we simplified their differences:
- For small and large businesses: No matter what the size of your business is, having sufficient cash reserves will help you suffice for short-term needs. For bakeshop business owners, this means having an emergency fund to increase inventory during high-demand seasons.
- For banking institutions: Banking institutions are mandated by the U.S. Federal Reserve to keep a certain cash amount in reserve. This amount is determined as a percentage of deposit liabilities or the money people and companies deposit in banks that need to be repaid in the future.
- For private individuals: Cash reserves are not only limited to banks and businesses. In fact, individuals are advised to keep cash reserves (or what we popularly refer to as emergency funds) amounting to at least three months of your monthly income for emergency purposes. You can choose to hold your cash reserves in a separate bank account or in stable investments that won’t affect your money’s worth regardless of stock market performance.
Why does your bakery business need a cash reserve?
All businesses regardless of size need cash reserves to cover temporary expenses you never saw coming. It is the source of funds you can use to pay for various purposes, such as:
- Repair, upgrade or replace old equipment
- Purchase new machinery
- Hire temporary or outsourced staff
- Cover for bill shock
- Pay for health emergencies
- Purchase additional raw materials to meet customer orders
- Run seasonal marketing campaigns
- Repair any furniture or light fixtures in the bakeshop
How to compute your bakeshop’s cash reserves
Experts say that your ideal cash reserves should be anywhere between five and ten percent of your revenues. But if you want to have a general idea of how much should be in your funds, follow these steps.
- Step 1: Know your working capital by subtracting your current liabilities from your assets.
- Step 2: Check your cash flow statement and look at your total operating expenses for the past year. Divide that amount by 365 to get your daily operating expenses.
- Step 3: Divide your working capital – the amount from the first step, by your daily operating expenses – the amount from the second step. This will tell you how many days of funds you have on hand to keep your business running.
Another way to determine your cash reserves is by multiplying your average monthly expenses by the number of months you want to buffer. For example, if your operational costs are $10,000 monthly and you want to cover at least six months’ worth of your expenses, then just multiply $10,000 by 6 and you’ll get a target cash reserve amount of $60,000.
When it comes to cash reserves, there’s not one strategy that works for everybody. Some small business owners simply set a certain amount on their bank account, say $50,000, and keep that amount for as long as they could or until such time, they will need the funds. The key is to start small and continue finding the best method for your business.
An important rule of thumb: Don’t set your cash reserves too high or too low
Think that more cash reserves mean a more profitable business? That’s not always true. Having high cash reserves usually indicates that you’re not reinvesting money into your business. You could have used some of the funds for expansion, and therefore earn you more money.
On the other hand, having low cash reserves would be detrimental to your operations. Without sufficient funds for emergencies, you won’t have enough financial cushion during a crisis.
The Federal Reserve Bank of New York revealed that 47% of small business owners would use their personal funds to support their business through difficult times. Even if you own the business, you must always separate your personal and professional accounts.
No time to waste
Cash reserves are not business nice-to-haves. It’s a crucial investment you make for your bakery for when you go through a rough patch. The key is to regularly check your cash flow and see if you can turn some unnecessary expenses to cash reserves. Also, look at your assets - is everything still valuable to you, or you can sell some of them already?
Treat your cash reserves as a non-negotiable business expense. Automatically set aside a portion of your income to your reserves monthly. This will keep you accountable in keeping a healthy number in your bank account.
About the Author
Matthew Gillman is a business financing expert with more than a decade of experience in commercial lending. He is the founder and CEO of SMB Compass, a specialty finance company providing education and financing options for business owners.