Small businesses play an important role in driving the U.S. economy. More than 99.9% of all firms are small businesses, accounting for more than 31.7 million businesses, according to the Small Business Administration (SBA). Owning or managing a small business can be rewarding, but it can also be a challenge. A small business emergency fund can help smooth out the bumps.
A third of small businesses close within the first 2 years of operation. About a quarter survive 15 years. The SBA also reported nearly 900,000 small businesses closed in 2017, the most recent year a pre-pandemic study was done.
The top reasons these businesses close are because of either low sales volume or a lack of cash flow.
To protect your business, it’s important to establish a business emergency fund.
What Is a Small Business Emergency Fund?
A small business emergency fund is money you set aside to handle expenses related to unexpected and dire situations, such as a temporary shutdown, enduring slow periods of business or unplanned events that impact sales.
A fire or tornado damage might be an example of an emergency, but it’s not just about natural disasters. Business can be unpredictable. During the COVID-19 pandemic, many small businesses experienced significant impacts on their supply chains. With multi-month delays in getting goods shipped, many businesses were left without products to sell.
The Benefits of Business Emergency Funding
A business emergency fund acts as a financial cushion to help keep your company running during difficult times.
Setting up a cash reserve fund provides peace of mind. You’ll sleep better knowing that you have some money set aside to handle emergencies. Even if something does impact your business, you will still be able to take care of your obligations. With the right emergency savings goal, you will be able to pay your mortgage, take care of your utility bill, and pay your employees.
By creating a business cash reserve account, you also will avoid having to dip into your personal funds to keep your business afloat. A study by the Federal Reserve Bank found 86% of small businesses surveyed said they “would need to take some action to supplement funding or cut expenses” if they had a 2-month revenue loss. Nearly half of them would be forced to use personal funds.
So, an emergency fund makes sense. The big question, however, is how much money should be in savings?
How Much Money Should Your Business Have in an Emergency Fund?
What would happen if your business suddenly had to close its doors for a month? What if an emergency caused you to shut down operations for two months? Depending on the financial health of your small business and your savings, the impact might be devastating.
Figuring out exactly how much to have in an emergency fund will be an important business decision.
Jody Grunden of Summit CPA Group advises clients to keep between 10%-30% of annualized revenue in the bank. That works out to be between 3 and 6 months of operating expenses.
That can seem like a lot, but if an emergency happens, you want to be prepared. This is especially the case if the alternative is to close up shop or turn to your personal funds.
Where to Set Up an Emergency Fund?
Emergencies are unpredictable. You never know when they will occur or when you might need to tap into your business emergency fund. As such, where you put your funds makes a difference. You may need to be able to get access to your savings quickly, which means keeping your money liquid.
Most small business owners choose to open interest-bearing savings accounts or money-market accounts. This way, you have access to cash when needed, but at least you are earning some interest on your balance. Certificates of deposit, mutual funds, or other investments may earn higher rates of return but it may be difficult to cash out in an emergency or have penalties for doing so.
Some businesses set up a separate account for their cash reserve fund. Others just keep the emergency savings in their business account.
How to Build a Business Emergency Fund
If you are a sole proprietor or small business owner with thin margins, getting started on building a cash reserve fund can seem challenging. However, there are several ways you can build up your business cash reserve account.
Determine Your Needs
The first step is to determine how much working capital you would need in case of an emergency. Your needs will be unique depending on your business.
For example, some businesses are more seasonal than others. If an emergency happens during your busy time, it may impact your finances for more than just a few months. In that case, you would want to have a larger emergency savings goal. If you have a business that carries inventory, you also may need a larger reserve to keep your supply chain operating efficiently.
Your personal financial situation will also play a role. Are you able to survive for a period if you are not drawing a salary or pulling money out of the business? If not, you will want to factor that into your calculations.
While 2 months of a business emergency fund may be enough for some businesses, others may want to fund 6-12 months.
Set Reasonable Goals
You’re better off starting small and ensuring you can meet your monthly savings goal than struggling to hit a bigger number. Set small, achievable targets for your monthly savings and increase the amounts when you are comfortable you can handle them without hurting your business.
As with any savings program, you need to put together a plan and follow it consistently. Commit to putting a certain amount of money aside each month. One of the easiest ways to do this is to save a percentage of your monthly revenue. While the percentage stays the same each month, the amount you save will vary depending on how much money you take in.
You’ll deposit less when revenue drops, but you’ll be able to balance out when you have a better month.
An effective way to build a financial cushion is to open a separate account and then set up a monthly deposit from your business account. Savings can happen without requiring you to manually move the money each month.
Another option is to transfer a portion or percentage of every transaction and deposit it into a separate account. For example, if your net profit margin on sales is 8% after operating expenses, consider putting 1% of every sale into an account until you reach your goal.
When Business Is Good, Save More
When you have a good month financially and you have a better net profit, put a little extra into your emergency business funding until you reach your goal. It can be tempting to use the profits for something else, but put off less critical expenses until you’ve saved enough to create your financial cushion.
Whenever you spend money, it’s one less opportunity to save.
Check for Nonessential Expenses
Certain expenses are unavoidable. If you have a mortgage on your property, you need to make the monthly payment. You’ll need to pay utilities and employees if you want to stay in business. However, other items aren’t essential.
When you’re trying to build your emergency fund, delay any nonessential items until you hit your goals. While you may need to replace a cash register or card reader that stops working, you can probably live with an old office chair or computer for a few more months while you’re building your savings.
Protect Your Emergency Fund
It can be tempting to dip into your emergency fund for things that aren’t emergencies. Avoid the temptation to use your emergency fund to pay your estimated quarterly taxes if it is all possible. While you need to pay your taxes, you should be planning for it and not dipping into cash you’ve set aside for emergencies.
When you reach your goal, take a breath and congratulate yourself. It’s a big step. Consider continuing to save and build your cash reserve fund to create an even bigger financial cushion. If an emergency occurs that lasts more than the 2 to 3 months you have saved, you’ll be glad you kept saving.
While you want to keep your emergency business funds liquid, amounts over and above your goal can be put into longer-term investments that pay higher dividends. Certificates of deposit (CDs) or bonds, for example, will earn more interest than a savings account but still be accessible in the future. Just make sure your short-term emergency account is fully funded first.
Prepare for the Unexpected
If you already have a business emergency fund in place, it’s worth assessing it to make sure it still meets your goals.
If not, start now and be better prepared for whatever comes your way.