If you lost your best-paying client today, how would you make up the difference in income until they were replaced? If the economy stalled and your customers put a hold on orders, could you keep your business running until things picked up? Setting money aside in a rainy day, or emergency, fund can help you stay afloat during severe or unexpected downturns in your cash flow. It takes discipline and planning to open and maintain them, but they should be part of the overall financial strategy for practically every business. Here are three expert viewpoints on how best to manage them.
Ask three key questions
While the general idea of a rainy day fund is probably understood by most business owners, the particulars are often up for debate, even among financial professionals. "It's not a fund, but a collection of funds," says Stephen Nelson, a Redmond, Washington-based CPA. "The most important part is that you've got enough cash to keep the business going."
Nelson says that money in one fund might cover your expenses if a client is late in paying or if a vendor demands payment sooner than expected. A second fund could be tapped if you lose a major customer or a vital employee departs, along with the income they generated.
There is no one formula to figure out the amount of cash to set aside, but Nelson breaks the problem down by starting with three questions. First, how much extra cash does your business need to smooth out any short-term bumps? "If your small business is scrambling to pay the bills, the simplest thing is to have a bigger business or checking account balance," Nelson explains. "You just have to keep adding cash until you're out of scramble mode."
Second, how much would you need to survive a major disruption, such as the unexpected cancellation of a big order? Nelson admits that it is difficult to plan for something like this and suggests doing a Strengths, Weaknesses, Opportunities, Threats—or S.W.O.T—analysis to come up with contingency plans.
Third, how much money would you need if you had to close your business and find other work? "You don't want to be in a situation where you've depleted every bit of cash you have," Nelson says. "You're going to have some period of transition that will be different, depending on your business. You have to have a plan for this. Even if you're a successful entrepreneur, you may end one business before you're ready to begin the next one, so you need to be able to fund that."
The six month plan
While it would be tempting to use funds in a rainy day account to help pay for regularly scheduled expenses—such as payroll taxes, utilities, and insurance premiums—small businesses should draw from them for emergencies only. Still, this can be interpreted broadly.
"You try to estimate what could happen and then put money aside for that," says John McCoy of Westerville, Ohio-based McCoy Wealth Advisors. "Let's say the air conditioning decides to go out when it's 110 degrees or you've got to buy a new computer—these were things that you weren't expecting to happen that could hurt."
Like Nelson, McCoy says that there is no universal way to calculate an adequate dollar amount to store in a rainy day fund, but a careful analysis of your cash flow and expenses can point you in the right direction. For example, a business that derives 90 percent of its income from one client should have sufficient funds to cover its sudden loss—and then some. "When you're trying to replace customers, there is always a lead time to sign up new customers and then there's a lead time to get your first check from them," McCoy says. "It's not a quick process in a lot of instances."
McCoy says that a good target is to have at least three to six months of cash reserves in the fund. While each business is different, having a business plan that is reviewed regularly can be a good tool in figuring out an amount to have on hand.
View them like insurance
Depending on their circumstances, experts say that some businesses might prefer to have funds that last longer.
"You should set aside six to nine months of business expenses," says John Bonesio, co-founder of Roseville, California-based Simply Great Lives. "Business expenses mean keeping the lights on, paying the employees, and keeping the business open. It's not a percentage of income. It's an amount so that your business can survive six to nine months if you're not generating income."
Bonesio says that businesses should track what they spend their money on, do what they can to minimize expenses, and use the savings to fund the rainy day account. He prefers using a regular savings account or some other type of investment vehicle where the money is liquid and available whenever the business needs it.
"In a sense, having all the money in a savings account costs you because you're not getting a good return on your money. But you have to think about this rainy day fund like insurance. It costs you to have the insurance," Bonesio says, "but you're glad you have it when you need it."