What Is A Cash Reserve And How Does It Work?

When it comes to running a business or even going through life, there are plenty of roadblocks and unexpected events that will inevitably arise. That’s why having cash reserves is important so you can be prepared to face financial obstacles.

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

Cash Reserves Definition

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, like a money market fund, which is different from a money market savings account. Businesses can also place a portion of their funds in savings, checking or a business bank account. This type of emergency fund can be helpful when individuals or businesses experience unexpected financial hardships.

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 more easily to cover these types of expenses, saving you stress.

Individuals

Individuals can use cash reserves – in some cases called an emergency fund – to cover events such as a large health or dental expense, car repairs, home repairs and even day-to-day affairs in the event you lose your job. As mentioned above, any amount of money in a checking or savings account can count as cash reserves. Short-term investments may also be used as cash reserves, so long as they can quickly be converted into cash for use when needed.

Company

Businesses use cash reserves the same way as individuals, except 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 Pros And Cons Of Cash Reserves

Having cash reserves can be a blessing to your financial life, but too much saved can have its downsides as well. Here are a few of the pros and cons:

Pros

• Keeps you prepared: 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 to save for a down payment on a home, an unexpected emergency won’t hinder your progress if you have cash reserves.
• Protects you from using consumer debt: Having cash reserves also protects you (or your business) from consumer debt. In small amounts (and assuming you can pay it off quickly), consumer debt, like a credit card or personal loan, isn’t a big deal, but consistently relying on credit to fund your business or personal life could lead to financial trouble. For example, running up a high credit card balance and not meeting your minimum payments can hurt the credit score of yourself and your business.

Cons

• Can lead to missed opportunities: Having a large amount of cash on hand seems great, but too much can be harmful because it leads to missed opportunities. Beyond what you might need for an emergency, using extra cash to invest or fund business growth may offer higher returns compared to what it could make in a savings account.
• Lower returns: For individuals, having cash reserves may result in 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 has the potential to be much larger, though there is always risk when investing in business or the stock market.

How To Set Up A Cash Reserve Fund

Setting up a cash reserve fund is pretty straightforward for both individuals and businesses. Here are the basics.

Open A New Bank Account

Start by choosing a bank account that will suit your needs – hopefully one that earns some interest and allows you to access your cash quickly. You also can go with your existing bank if you like. Opening a new bank account doesn’t take a lot of time, and existing customers may find that it only takes 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 business license.

Set Aside 3 – 6 Months Expenses

While there is no set amount of money that will fix every problem, you’ll ideally want to set aside at least 3 months of expenses. This amount will help to offset longer-term emergencies such as cash flow problems or unexpected unemployment.

To determine how much money you need to live and stay afloat, look at your business cash flow statement or personal budget to see what it costs to cover your essential expenses each month. Don’t have a budget? You can easily set one up and get a sense of your spending using Rocket Money^SM. Once you have an account, Rocket Money will scan your transactions to report your average spend across categories that could be helpful. Once you have an idea of your total monthly spend, multiply it by the number of months you want to cover. Businesses should have this money set aside in cash or other liquid assets they can easily access to help with operating expenses.

Pay Back Used Funds

If you use money from your cash reserve, you need a plan to pay it back so that money can be used for the next unexpected expense. This could mean earning more money or cutting back on some expenses temporarily until your cash reserve is back to the amount it was before. For an individual cash reserves fund, try negotiating a bill or cancelling an unwanted subscription using Rocket Money. Any funds saved will help you rebuild your cash reserve fund quicker.

What’s The Difference Between Cash Reserves And A Cash Balance?

A cash balance refers to the amount of money available for the business or its employees, which is different from a cash balance plan that offers participating employees potential savings toward their retirement with a defined benefit, similar to a pension. Separately, 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 surprises life will bring. Having a solid amount of money on hand can prevent an inconvenience from becoming a major disaster or ruining your credit. Not sure how much you need to put away? Get started with Rocket Money to keep track of your spending across accounts, and even monitor your credit to get a full picture of your financial life.