How to build a cash reserve

A cash reserve is business money held apart from the everyday account, so it isn't spent by accident. It usually has three jobs: meeting large bills that don't come every month, carrying the business through seasons when less money comes in, and covering costs nobody planned for.

business.gov.au's guide to managing cash flow suggests holding money for regular bills in a separate bank account, so they can be met on time. Its advice on improving cash flow adds that a business with predictable slow seasons should make sure it has the cash to carry it until trade picks up.

A reserve is not the same as an overdraft or a credit limit. In business.gov.au's glossary, an overdraft is a facility from a lender that allows the account to go below zero. That is borrowed money. A reserve is cash the business already has.

There is no single right size for a reserve. Work yours out from three things in your own books:

1. Known irregular costs. List bills that don't come every month, such as insurance, licence renewals and vehicle costs. business.gov.au suggests keeping a list of due dates for the payments your business needs to make.
2. The quiet-season gap. Use your cash flow forecast to estimate the extra cash needed through quiet months, allowing for when surpluses can replenish it. Count each outflow once: do not add an irregular bill separately if it is already funded within that gap.
3. An allowance for the unexpected. A common way to size this is a period of your fixed running costs, such as rent and insurance, chosen to suit how predictable your business is.

Each line comes from the business's own records, so the target can be explained and updated when costs change.

Keep the reserve in a separate business account in the business's name, not in a personal account. business.gov.au points out that a business account makes it easier to track and control income and spending and to show business finances apart from personal ones. A separate reserve account does the same job for the reserve: its balance is visible at a glance and isn't mixed with day-to-day spending.

The money needs to be reachable when the reserve is called on. Whether a particular account or product suits your business is a decision for you and your bank or adviser.

A reserve built from whatever is left over at the end of the month rarely grows. Make the transfer a scheduled payment instead:

• set a regular transfer, weekly or monthly, that your cash flow forecast shows the business can carry
• add an extra transfer in strong months, when the forecast shows a surplus
• consider moving a set part of each large customer payment as it arrives.

Building a reserve competes with other uses for spare cash. business.gov.au's budgeting guide lists paying off debt, setting money aside for emergencies and growing the business as options when there is money left over. How to balance them is worth discussing with your accountant.

• Set the reserve account up as its own bank account in your chart of accounts.
• Record each transfer as money moving from the everyday account to the reserve account. It is not an expense and doesn't change profit.
• Record any interest the account earns as income.
• Reconcile the reserve account to its statement each month, as you would any bank account.

If the reserve sits in an account you can draw on at call, it is still cash on the balance sheet. business.gov.au's definition of cash covers money available on demand, including money held in bank accounts. So setting money aside doesn't change the business's working capital. It changes how much of that cash is earmarked.

Write down, before you need it, what the reserve is for and who can approve taking money out. A simple set of rules might be:

• the planned irregular bills on your list come from the reserve when they fall due
• anything else needs the owner's approval and a note of why
• every withdrawal outside the plan is followed by a refill schedule.

If the business keeps dipping into the reserve for everyday bills, treat that as a signal. business.gov.au treats a business that is always short of cash as one that may be in financial difficulty.

Check the target whenever you update your budget or forecast, and when costs change, such as a higher insurance premium or a new lease. Once the reserve reaches its target, the regular transfer can stop or shrink, and the money it was taking can go to other plans.