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What Is A Cash Reserve And How Does It Work?

Sarah Li Cain4-Minute Read
May 11, 2021

When it comes to running a business or even going through life, there are plenty of roadblocks and unexpected events that will inevitably arise. Without much-needed capital, what would happen? That’s why having cash reserves is important so you can face these obstacles.

Let’s take a deeper look at how you can build up a cash reserve fund.

What Are Cash Reserves?

Cash reserves are funds that a company or person sets aside in case of an emergency. Cash reserves can also refer to short-term investments, such as money marketing funds and treasury bills. Businesses can also place a portion of their funds in savings, checking or a business bank account.

How Cash Reserves Are Used

There are a wide variety of emergencies that can happen to individuals and companies at any given moment. Cash reserves allow you to access money quickly and easily to cover these types of expenses without having to stress too much.

Individuals

Individuals can use cash reserves — in some cases called an emergency fund — to cover events such as large health and dental expenses, car repairs and home repairs and to cover day-to-day affairs if you lose your job.

Company

Businesses use cash reserves in much the same way as individuals, except it’s for business-related expenses. Most of these aren’t emergencies per se, rather to cover unexpected events, expected losses, and to fund potential investments. Some events include a slow sales period, new purchases to keep daily operations running, and investments in business growth.

The Benefits And Drawbacks Of A Cash Reserve

Having a cash reserve fund can be a blessing and a hindrance to your financial life at the same time.

Benefits

One of the most obvious benefits to having a cash reserve fund is that it helps you prepare for unexpected expenses. As a result, your regular everyday funds aren't affected. In other words, it allows your current budgeting techniques to remain intact. For instance, if you have an aggressive savings goal save for a down payment on a home, an unexpected emergency won’t hinder your progress.

Having cash reserves also protects you (or your business) from having to use consumer debt. In small amounts (and assuming you can pay it off quickly), this isn’t necessarily a big deal, but relying on credit to fund your business or personal life could lead to financial trouble.

Drawbacks

Having a large amount of cash on hand seems great, but too much can be harmful because it leads to missed opportunities. Using the cash for investments or to fund business growth may offer much higher returns compared to what it could make in a savings account. For individuals, having cash reserves could cause lower returns compared to sticking the cash in an investment account. Over a long period of time, the difference between having money in reserves and investments could be huge.

How To Set Up A Cash Reserve Fund

Setting up a cash reserve fund is a straightforward process, for both individuals and businesses. Here are the basics of setting one up.

Open A New Bank Account

Start by choosing a bank account that will suit your needs — hopefully one that earns some interest and that allows you to access your cash quickly. You can go with your existing bank if you wish. Opening a new bank account doesn’t take a lot of time, and existing customers may find that it’ll take merely a few minutes.

Depending on whether you’re opening an account as an individual or a business, information you’ll need to provide may include your name, address, Social Security number or Employer Identification Number, and your business license.

Set Aside 3 – 6 Months Expenses

Ideally, you want to set aside at least 3 months of expenses because this amount will help to offset longer-term emergencies such as cash flow problems or unexpected unemployment. To determine your exact amount, look at your business cash flow statement or personal budget to see what it costs to cover your essential expenses each month. Use that number and multiply it by the number of months you want to be able to cover.

Pay Back Used Funds

If you use money from your cash reserve, you need to make a plan to pay it back. That’s because the money is meant to help you during unexpected events — a safety net, if you will. Once you take the money out, make a plan to determine how you’ll top up your funds. This could be earning more money or cutting back on some expenses temporarily until your cash reserve is back to the amount it was before.

Understand Undercapitalization And Overcapitalization

Undercapitalization is when a business doesn’t have enough funds or cash flow to meet its current business needs. When this happens, it’ll have to rely on reserves or debt to cover expenses.

Overcapitalization, on the other hand, means that a company has raised too much money from investors. This means the market value of the company is lower than the actual value, leading to paying more in dividend payments and interest than it can sustain. Having cash reserves can combat this while the business works to restructure its finances.

The Difference Between Cash Reserve And Cash Balance

Cash balance refers to the amount of money available for the business or its employees. A cash balance plan offers participating employees potential savings toward their retirement. Cash reserves refers to money kept on hand in case of emergencies, and is more liquid. 

The Bottom Line: Cash Reserves Protect You From A Financial Disaster

Cash reserves are essential because you never know what will happen — having some money on hand can prevent an inconvenience from becoming a major disaster. Learn to prepare for the uncertain by setting up a personal emergency fund or a small-business emergency fund.

Sarah Li Cain

Sarah Li Cain is a freelance personal finance, credit and real estate writer who works with Fintech startups and Fortune 500 financial services companies to educate consumers through her writing. She’s also a candidate for the Accredited Financial Counselor designation and the host of Beyond The Dollar, where she and her guests have deep and honest conversations on how money affects our well-being.