Can there be uncertainties specific to a business?
We often hear the importance of ‘Emergency fund’ when we plan our personal finances to protect ourselves during sudden unexpected events in our lives.
But how is it relevant to a business?
It is a general practice for companies to create a ‘Provision’/ ‘Cash Reserve’ in their balance sheet.
A Provision/Reserve is profit set aside to cover probable outflows of cash of which the amount can be ascertained with some reliable estimation. E.g. – repairs to an asset, legal claims, warranties, guaranties, refunds, changes in income tax system, etc.
Accounting is built around the concept of prudence, also known as conservatism – which says all prospective losses and uncertainties should be recognised. Which is fair enough because a sudden outflow can cause a massive monetary impact if not prepared for.
I understand most of the above still sounds complicated and irrelevant to your business, specially if your business is in the first 5-8 years, or you are a sole trader.
Let us look at Key Situations Where a Cash Reserve Is Essential for Your Business
1) You are a sole trader:
a. You would like to go on a month-long family holiday every august which will directly impact the ability of your business making revenue – it is probable your business will make loss for that period and hence you need a cash reserve to pay off your fixed costs for that period.
b. You are likely to go on a maternity or a paternity leave in the next 1 year – once again probable your business will incur loss, and you need a cash reserve to cover fixed costs.
2) You are in the first 5 years of business:
a. It is likely you would have fluctuating profits in the initial years, hence wise to have a cash reserve for those slump months.
3) If you are a product-based company:
a. It is probable for a machine breakdown or stock damages to occur, hence wise to set aside profits into a cash reserve to cover repairs and loss of revenue.
b. Warranties and refunds are a common practise when a product is sold hence being prudent with revenue is a wise practise.
Circumstances can vary but the objective is the same – set aside profits into a cash reserve for those months/events you are likely to make less or no revenue.
You have put a lot of efforts into building this business of yours, be sure to protect it from uncertainties and that is when you will have a strong financial foundation.
Eager to build a strong financial foundation for you and your business? Book a free call with me or a book yourself onto an upcoming webinar/workshop to learn more.
Written by
Mrudula Muralidharan
Founder and Finance Coach
Million Goals
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