What Is a Cash Reserve? (Definition, How-To, Pros and Cons)

Updated September 30, 2022

Businesses may incur considerable expenses from daily operations, which can add up quickly. It's essential that a company has access to money to help settle any unprecedented short-term expenditures as they arise. Understanding what reserve funds are can help you prepare a company against emergencies, such as a drop in revenue or a need to finance a purchase.

In this article, we define a cash reserve, explain how it works, highlight some pros and cons of keeping one, share the motives for building one, and discuss the steps for establishing a fund.

What is a cash reserve?

Cash reserve, also known as a reserve fund, liquidity buffer, or cash pool, is the total sum of money saved by a business to address emergencies. Companies may save the cash in an account and use it to cover unplanned expenses. Aside from fiat currencies kept in banks, companies may store them as treasury bonds or any short-term, highly liquid asset they can easily exchange for money.

Read more: What Is Cash on Hand? (Plus Benefits and Tips for Managing It)

How does a reserve fund work?

Reserve funds operate differently depending on the entity that owns them. Here's an overview of the three ways they may work:

  • Reserves for individuals: For individuals, a reserve fund comprises money stored in savings accounts, current accounts, and market money funds. It can also refer to any money stored as a stable short-term investment like a certificate of deposit and treasury bills that give their fiat monetary equivalent in the future.

  • Reserves for business: Companies may hold cash to protect themselves from financial vulnerability. They can also have a reserve to finance potentially profitable investments.

  • Reserves for banks: Bank reserves are the minimal amounts of cash necessary for financial establishments to have in their bank vaults. A country's central bank typically determines the minimum cash pool that banking firms can maintain.

Related: What Are Accounting Transactions? (Definition and Examples)

Pros of keeping a reserve fund

The primary purpose of creating and maintaining a reserve fund is to have a contingency plan in case of unplanned purchases. Although, there are other ways in which a business might benefit from owning a reserve fund. They include:

Helps finance a business's growth and expansion

Business owners and executives may search for options to accelerate a company's growth. Often, money is necessary to finance these developments. With a reserves account, a business can have access to funds, which can help make timely decisions on purchases and boost business growth.

Reduces dependency on loans

Usually, debt financing and equity are two common ways to generate capital. Banks typically record funds accumulated using these options as loans. These loans may strain a company's profit margin because of their interest fees. By creating a liquidity buffer, a business can avoid any needless inconvenience associated with taking loans.

Helps to maintain a positive cash flow

Cash flow refers to the in and out movement of money from a company's account. It's one of many metrics to evaluate a business's costs incurred during operations. A substantial reserve can help settle interest fees from loans, returning the firm to a favourable standpoint related to cash flow. A positive flow indicates that a company has a sufficient cash pool to pay its bills and may not require further financing throughout the particular period a statement reflects.

Related: What Is Cash Reconciliation? (Systems, Benefits, and Tips)

Provides security against all financial risk

Every company, firm, or individual often bears some financial risk. It's normal to encounter losses from time to time. Although it's sometimes impossible to scale how much of a loss a company can incur in the future, having a solid reserve fund can help ensure a business has enough cash to handle the operational and financial impact of the loss.

Helps cover the lean period

Some companies may have an uneven inflow of revenue that may rise or fall, corresponding to seasonal changes. These are also referred to as seasonal businesses. For several weeks or months of the year, these types of businesses may have a low and inconsistent flow of money. Creating a liquidity buffer protects the company against potential bankruptcy within this period.

Related: A Comprehensive Guide to Cash Management (With Definition)

Cons of a reserve fund

The following are some possible drawbacks of keeping a reserve fund:

Missed profit and investment opportunities

Every company may have its own unique operating processes. While some may be able to generate excess cash for possible unforeseen circumstances, others may struggle to do the same. Sometimes, companies may not have the expertise to differentiate between having sufficient and excessive working capital, which may affect the business. An excessive reserve may lead to keeping cash stagnant, which might cause a business to miss several opportunities for generating additional revenue and investments.

Loss of cash value

Suppose a company receives interest on its reserve fund at a rate below the inflation level over the long term. In that case, it may experience a loss in terms of its ability to purchase actual goods and services. That's because the cash's value may decline over that period. Over time, this situation can affect the financial health of the company.

Related: What Is Cash Flow? Definition, Types, Template, and Example

Motives behind building a cash reserve

A functioning business may keep money readily available for several reasons, which you may attribute to the following motives:

Transaction motive

To a degree, a company can usually estimate expenses for operating activities. This reasoning involves considering the cash required to resolve all costs incurred from daily operational activities and keeping a reserve to handle adjustments in working capital and non-cash items. Professionals may refer to it as cash flow from operations, and some examples include:

  • Corporate tax payment

  • Salaries and wages

  • Account receivable payments

  • Account payable payments

  • Cash received for products or services sold

Related: What Is Management Reserve for Project Budgets? (And How-to)

Precautionary motive

This reasoning entails keeping cash to prevent possible unforeseen situations. Companies, banks, and individuals may maintain reserves to handle uncertainties, emergencies, and difficult situations. For instance, an individual might decide to save money to plan for the possibility of an accident.

Speculative motive

This motive involves holding cash in the expectation that a company or individual can use the money withheld for other profitable ventures. This reserve can help the company invest in these opportunities quickly without waiting for profits or taking a loan. Doing this can also help the company grow without affecting its working capital, which it uses for daily operations.

Related: What Is Projected Cash Flow? (And How to Calculate It)

Ways to build a reserve fund

Liquidity buffers are often essential to strengthen a business's financial security. Here are some tips on how to build a reserve for a business:

  • Monitor cash flow constantly: Tracking the in and out flow of money can provide insights into the revenue generated, and the estimated expenses a business incurs within a given time frame. Doing this can help you determine a suitable amount to keep as a working capital reserve.

  • Assess the business model and industry: You can check for factors like seasonality and operational expenses to understand how often the company relies on cash to operate its daily activities. Because of their structure, certain businesses may not have high recurring maintenance expenses, so it may not be necessary to store large amounts of money as a contingency fund.

  • Evaluate opportunity cost: Opportunity cost refers to the potential benefit forgone for another alternative. Here, it involves scaling the benefits of holding money against investing it because it's essential to consider the investment opportunities available to a business before determining how much to allocate as reserve funds.

  • Account for a reserve fund when creating a budget: You can treat a company's reserve fund as an additional expense and include it in the budget. By doing this, the company can consider it an operational cost in the accounting system and allocate cash for it.

  • Track all assets and the frequency of use: You can monitor all inventories owned by the company and note the frequency of use. Leasing or selling the least used assets can be an excellent way to generate funds for a company's reserve.

  • Create a payment plan. When building a reserve fund, it's also essential to create a payment system to balance the money needed to handle difficult situations. You can consider possible factors that may contribute to a company using its emergency fund and apply that to formulate a payment plan.

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