It’s widely documented that around 30% of Americans would need to sell something, or borrow, to cover an unexpected expense of $400. In another study, 58% of individuals reported they have less than $1,000 saved. Americans clearly have difficulty saving personally, is this also true for businesses? Do they need savings?
82% of businesses that close, close because of “cash flow issues” (SCORE). Meaning, they fell on hard times or slow revenues and didn’t have the cash to cover expenses. Saving allows owners a “bridge” to make it through difficult months without taking on debt, while also giving them capital to advertise or market if they see revenues dwindling. It allows them to balance out cash flow during lean times.
If an emergency savings account is not readily available and funded, business owners only have loans, lines of credit, and other forms of debt as their safety nets – a risky and potentially catastrophic alternative to cash.
Emergency savings are not exciting or flashy like investments, profits, or expansion. Savings are the spinach of the financial world – boring, flavorless, but packing a punch. As businesses have struggled through the COVID-19 crisis thus far, it’s become clear how few businesses (both large corporations and small “mom and pop” businesses) are prepared to handle their expenses once revenue dries up. Saving is not the norm, but the exception.
This leads to a few questions. How much to save? Where to keep savings? Most importantly, how to create a system to force owners to save monthly.
First, how much to save? The personal finance rule for emergency savings is 3-6 months of living expenses. That’s a solid starting point for businesses, but 6-12 months would be a better goal considering the current economic times and fluctuating revenues of most small businesses. Just like personal finance, the amount of savings should also depend on the “risk” of the industry the business is in. For example restaurants (typically one of the more volatile industries) should save a great deal more than an accounting firm.
This calculates to a hefty amount of savings (Likely somewhere between $60,000-$300,000+ for small businesses). A seemingly insurmountable amount for a business struggling to make a profit. In reality, this is the end result of a saving process that likely will take years, depending on the cash flow of a business. The key point to remember is this is a process and will take persistence.
This leads to the next question. What system can be used to force saving habits when margins are tight? A great starting point is to save a certain percentage of all revenue. For example, starting out, move 2% of revenue into savings. This could be done for each deposit, once a week, or twice a month. Once owners see that the 2% is possible, the percentage can slowly be increased month over month until savings are growing at a quick rate. The benefit of this system is it allows owners to save within their means. When business is slow, they’re still only saving 2%. When it’s a great month, 2%, it’s a very simple process.
This saving may be increased to 5-10% until the 6-12 months of expenses are reached, but if budgets are tight, 1-2% can continue to be used indefinitely. If this percentage system really resonates with business owners, I would encourage them to read “Profit First” by Mike Michalowicz. It’s a more expanded version of this percentage system of saving and spending.
Finally, where should this money be saved?
First, the money should be saved in a separate account. If savings are kept in an operating account, the temptation to spend it on non-emergencies will be much greater. At all costs, separate the savings.
If possible, a high yield savings account is the best vehicle for savings. This describes a savings account that makes 1-2% in interest instead of the average .01% most banks offer. These accounts are often offered by online-only banks and will allow you to make a small amount of interest on your savings (1-2% of interest adds up quickly on 6-12 months of expenses). Whichever account is chosen, the point of this account is liquidity, not growth, meaning that it must be easily accessible. This means that this money should not be invested (where withdrawals may trigger tax penalties) or put into a CD in which it cannot be withdrawn for a specific time period.
As owners begin their emergency savings they may also want to consider saving for business taxes (10-15% of revenue is a good benchmark to set, if profitable) as well as retirement. I would recommend a separate savings account for each.
Setting up emergency savings for a business is a long, difficult process and many business owners will not be able to persist long enough to fund it fully. But, once set up and funded, it will provide peace of mind and security that owners will never want to give up. Most importantly, it will allow businesses to survive and even thrive in the midst of downturns, slow months, and unforeseen circumstances.