Operating Reserves: A Necessity for Sustainable Success

In today's ever-changing economic landscape, being proactive is the key to business survival, whether you're a small enterprise or a nonprofit organization. The world is inherently volatile, and as such, there's an increasing need to create a solid financial safety net to protect your operations, your human capital, and your mission. Today, we'll delve into why it's crucial for businesses to establish an operating reserve, highlighting key considerations that apply to both small businesses and nonprofits.

The Volatility of the Economic Landscape

The past few years have shown us just how unpredictable the economy can be. This uncertainty underling the need for creating a financial cushion. An operating reserve acts as a shield, safeguarding your business against unforeseen economic storms. It ensures you have the cash needed to cover operating expenses, pay employees, and retain the human capital that's so vital to your success.

Determining the Right Cash Reserve Amount

While there's no one-size-fits-all answer to the question of how large your cash reserve should be, a general guideline is to aim for at least three months' worth of operating expenses or 25% of the annual operating expenses. However, this target may vary based on your specific circumstances such as revenue predictability, spending flexibility, and the cash flow patterns. To calculate this target reserve, many entities often turn to historical financial statements. But here's the catch: historical numbers don't account for future needs and are usually prepared according to the accrual basis. Relying solely on the past may not provide the level of security your business or nonprofit requires.

A Recommended Approach for Reserve Planning

So, what's the right approach? Start with projected financial statements. Create a detailed projection of your cash flow and anticipate your future cash burn rate. Once you have a clear picture of your financial future, establish a separate bank account for your reserve funds. This segregation is crucial to avoid mixing your operating funds with your reserve.

It's wise to take a gradual approach to building your reserve, allowing you to accumulate the necessary funds over time without disrupting your day-to-day operations. Special cash windfalls can certainly expedite the process. As your reserve grows, consider investing the funds to improve your overall return on assets. A laddered maturity approach can be beneficial here; divide your reserve into equal portions and invest them and structure the maturity dates in fashion that ensures cash availability and reduces penalties for early withdrawal.

It's important to reevaluate your future cash needs regularly and adjust your reserve balance accordingly. Furthermore, seeking the advice of an experienced investment manager can help ensure that your reserve is managed in a way that maximizes its potential.

Some businesses with expansion plans may need to create a capital reserve to meet future capital expenditure (CapEx) requirements. In this case, it is prudent to separate the two reserves accounts as it is easy to lose sight of the purpose of each reserve and end up with unpleasant surprises.

Bonus point for S-Corp.

Business literature usually addresses cash reserves as an essential tool for nonprofit organizations. Nonetheless, I believe building a solid reserve is equally important for small businesses. Especially at the early stages, when they are more vulnerable to economic downturns. As we discussed in a previous article, the sole purpose of an S-Corp. is to reduce self-employment tax liability by classifying a limited portion of the distributions as salary. The IRS requires a reasonable estimate of the salary but it can’t force the distribution of income. Accordingly, an S-Corp. that withholds a portion of its income to build a reserve stand to save 15.3% in self-employment on that reserve amount. So practically the tax-payer is building a reserve to meet economic challenges or even fund future expansion, while saving more than15% on these funds!

Whether you’re an entrepreneur or a founder of a nonprofit, you need an effective plan to mitigate uncertainties. By taking a strategic and informed approach to reserve planning and management, you're better equipped to thrive, adapt, and face whatever the economic future may hold.