A lack of available capital can be a tremendous obstacle to businesses as they try to survive difficult economic times or grow the company. In fact, 20% of small business owners say a lack of available capital is a top challenge for them. And in turbulent financial times, a lack of cash on hand can spell a quick end for a small business, as half of them hold a cash buffer of just 27 days.
The nationwide shutdown in 2020 has demonstrated the urgent need for small businesses to have emergency funds in order to continue operations or stay afloat while completely or partially closed.
Emergency funds are simply liquid savings accounts that can be tapped by businesses when they need them—reserves that are not touched for day-to-day operations.
Certified Public Accountant (CPA) Kenneth Bucci told The Balance during a phone interview that many businesses use emergency funds when they see a downturn in revenue due to a recession or economic crisis. However, he said they can also be critical in keeping the business afloat in other circumstances, such as losing a major customer, industry changes, or even a lawsuit.
Pros and Cons of an Emergency Fund for Your Business
Having an emergency fund for your small business may sound like a simple decision, but experts advise that all businesses, no matter their size, have an emergency fund of some sort because most small businesses will run into cash flow issues at some point.
According to data from the Federal Reserve, in the 12 months prior to being surveyed, 66% of small businesses had faced financial challenges, with the most common being paying operating expenses (43%).
Understanding the pros and cons of emergency funds can help ensure you have the right amount on hand.
No need for personal funds
Avoid credit and late fee issues
Lack of return
- Risk reduction: An emergency fund reduces the risk of being derailed by a surprise. Bucci said that a variety of unexpected issues can come up: illness of the owner or key employee, decline in the industry or interest in the product, or a recession or downturn in the market. Having a reserve fund allows you to continue operations through a tough time.
- No need for personal funds: Should you experience a financial challenge, you won’t have to use personal funds to mitigate it. Faced with a two-month revenue loss, 86% of small businesses reported they’d need to take some action to supplement funding or cut expenses—and for nearly half, that action would be relying on the owner’s personal funds.
- Avoid credit and late fee issues: You won’t need to rely on expensive credit or incur late fees. Without an emergency fund, a dip in revenue could mean that you can’t pay your bills on time, which means you may be putting your operating expenses on credit cards or paying late fees. Worse, you may not be able to meet payroll.
- Investment limits: Building an emergency fund can limit how much you invest in your business. While it’s important to have emergency reserves, balancing the money you put aside with what needs to be invested day to day in your business can be a challenge.
- Lack of return: Your money won’t see much of a return in a liquid emergency fund, especially when interest rates are low.
According to Bucci, the best places for an emergency fund are a traditional savings account or a money market account, so they can remain liquid if you need them. However, the interest rates on those types of accounts can also be very low.
How to Determine the Size of Your Emergency Fund
Experts have varying opinions on the amount you should keep in reserves, and it’s largely dependent on the other factors that affect your business, as well as your operational costs.
When deciding how much to stash away for an emergency, consider the following:
- Receivables and inventory: Businesses whose receivables drag out, or who carry inventory, should have more in reserves, Bucci said.
- The structure of your business: Are you a sole proprietorship? Do you have employees? Bucci recommended thinking through the consequences of losing revenue in terms of your ability to continue operations.
- Your personal positioning: Do you have personal savings that mean you could go without a paycheck for awhile? Is this a side or passion project, in which case you may need little or nothing in reserves?
- Seasonality: Businesses that are seasonal or cyclical may want to consider more in their emergency fund. “More volatility in the business means that they should have more in emergency funds, with three months being the minimum and 24 months on the high end of the spectrum,” Jessica Mah, founder and CEO of InDinero, which provides accounting services to small businesses, told The Balance via email.
How to Decide Your Target Amount
Consider the above factors to decide how much you’ll need to be comfortable with the circumstances surrounding your revenue and operational costs. According to Bucci, two months or more of payroll is ideal, but you should have one month’s worth at a minimum. Mah said that businesses should have at least three months’ worth of expenses saved.
According to Mah, you can also begin siphoning off some funds from the business into an emergency fund as soon as you have a handful of employees.
How and When to Use Your Emergency Fund
The first thing you should decide is where to keep the emergency fund. For smaller businesses, Bucci said the best option for liquid savings is typically a business account at a bank. But if you have $100,000 or more in your fund, Bucci suggested considering a money market account, which may give you slightly more interest on the account.
Bucci pointed out several critical moments when emergency funds can be put to use, including:
- A downturn in revenues due to a recession or lack of interest in your product or industry
- The loss of a major client that made up a significant portion of your business
- The loss of a key employee that will result in sales loss or require a significant amount of time and money to replace
- An inability of the owner or key employee to work due to illness or other issues
- A lawsuit—a rare but possible happening
- Any other circumstance where your income is not meeting your expenses, and you are unable to cover the difference through other means or by decreasing operating expenses
Setting Up Your Emergency Fund
Research the Best Bank or Credit Union for Your Business
According to Bucci, you may want to use additional services from the bank or credit union you use in the future, so it’s wise to find one you’re comfortable with and begin building a relationship.
Open an Account
Once you find the right financial institution, open the account that works for your business. Whether it’s a business savings or money market account, Bucci said it should only take about a day.
Begin Saving Regularly
According to Mah, you should deposit a specific amount into the account every month and pretend it doesn’t exist—like you would a rainy day fund. Making it a priority will help you save more money in the long run.
Alternatives to an Emergency Fund
While emergency funds are essential for the security of your business, the truth is that sometimes unexpected circumstances come up that are nearly impossible to be prepared for—and larger than the funds you have saved. If you’re caught in a situation where you don’t have enough in emergency reserves, there are some other strategies you can employ.
- A bank line of credit: Mah said another option is opening a line of credit with your bank to give you an extra few months of flexibility on top of your emergency fund. You can also borrow a home equity loan or line of credit, or borrow against your receivables or hard assets, Bucci added.
- Contact the Small Business Administration (SBA): When you can’t get traditional financing—which is typically only possible if you have receivables or hard assets to borrow against—the SBA is often able to help.
- Reduce expenses: If you don’t have the money to cover operating expenses, go through line by line and decide what can be trimmed back to help reduce the burden.
- Strategically partner with other companies: Consider sharing real estate, employee pools, or other resources to cut down on overhead while continuing operations.
Switch to contract employees, or outsource the work: If you can’t meet payroll, consider outsourcing work or hiring freelance or contract workers. This may provide a less expensive alternative to help you get through a downturn.