What is a business emergency fund and does my business need one?

No doubt you’ve heard the saying, “save some money for a rainy day.” Well, it turns out that it’s not only good personal advice, it’s also solid and trusted small business advice. In the business context, such savings are typically called “business emergency funds”, “capital reserves” or “retained earnings.”

A business emergency fund is a savings account that you create and contribute to regularly. The money is set aside in a separate bank account and is not accessed for anything other than specified “emergencies.” Here’s why you should consider building a business emergency fund and how to get started.

Why do I need a business emergency fund?

A few years ago, such a calamity like a worldwide global pandemic was almost unthinkable. Even though Covid was hardly foreseeable, those small businesses that set aside emergency funds were undoubtedly better prepared for the ensuing economic downturn than those who had not.

Setting aside emergency funds means that should the unexpected arise, you and your business will be ready.

An emergency fund can help with those far more common and mundane tasks than a once-in-a-hundred-year event. Consider the things for which that rainy day, emergency fund could be useful:

• Natural disasters, such as hurricanes, tornadoes, fires or floods
• Man-made emergencies like break-ins or computer hacks
• Medical emergencies to you or key employees
• Legal problems stemming from customer injuries, breached contracts, lawsuits
• Physical damage to your building or business from broken pipes, power outages, or HVAC issues

What are the benefits of an emergency fund for my business?

The first and main benefit of having a business emergency fund is security.

As a business owner, you must consider the future. You do this as you plan sales, revenue, taxes, and tax payments. Adding potential emergencies to that list, and saving up and setting aside funds, helps ensure the continued, long-term viability of your business.

In addition, a business emergency fund protects you financially. If something unexpected happens, the funds you put aside can give you and your business additional protection by not having to dip into normal working capital to manage the crisis.

Safety and financial security are not the only benefits of saving for a rainy (business) day, because the emergency doesn’t need to be negative for the fund to come in handy. Say one of your products becomes a hit, goes viral, and you need funds to quickly replenish the stock and take advantage of the momentum. Your business emergency fund could be used for that as well.

The final benefit is that your emergency fund can earn you interest as it sits in an interest-bearing account.

Three tips to remember when building your emergency fund

1. Plan for the worst

You cannot predict the unpredictable, but you can save and plan as if something bad might happen. If, for example, you had to shut down for a month, would you be able to re-open? What about three months? Emergencies we’re discussing here are drains on capital, so you need to do is save enough such that, should an unexpected event happen, you aren’t suddenly cash poor.

2. Plan for the expected too

Some cash challenges can be expected and as such, they too should be part of your planning and saving. For instance, if a recession is in the forecast, plan for it.

Similarly, if you have a seasonal business, it’s smart to save as if one season is not the norm; that way, when it is, you’ll be ready.

3. Save consistently

You do not need to create your business emergency fund all at once. Instead, build it up over time so that you feel less of a pinch and still receive the benefit. Two tips:

• Make it automatic. Just as you might automatically take money out every month to put into your 401k, you should also make saving for a business emergency an automatic event. And set the money aside in a separate bank account.
• Save more when you make more. When you receive a windfall, say from a big new contract, use it as an opportunity to set aside extra into your business emergency fund.

How much should you put in a business emergency fund?

It depends on your business, but as a rule of thumb, 10% of your annual revenue might be a good benchmark. Another option might be to have at least three months’ worth of business expenses in the bank. If your overhead is $5,000 a month, then having $15,000 saved up would be best.

It also doesn’t hurt to save more, especially because that money 1) will be useful if you need it, and 2) will be earning interest for you when you don’t need it.

Where should you keep your business emergency fund?

Again, it’s best to keep your emergency funds in a business savings account at a bank. A good business savings account will both allow you to access funds any time you want or need, while simultaneously growing that fund.

Another low risk option is a business CD, or certificate of deposit. A certificate of deposit offers a fixed interest rate that's usually higher than what a regular savings account offers. The tradeoff is you agree to keep your money in the CD for a set amount of time, typically three months to five years. Make sure to find a no-penalty CD so that in the event of an emergency, you are not hit with early withdrawal fees.

Bottom line

As a small business owner, you must think about the bottom line. One of the best and smartest ways to do that and protect the future of everything you have worked so hard for is to create a business emergency fund. The good news is that doing so is easy and the long-term benefit is significant.