Starting a Business Emergency Fund

Every business needs a solid emergency fund to withstand unexpected events, like fires, natural disasters, and recessions. An emergency fund can also help you get through short-term cash-flow crunches and take advantage of business opportunities that may arise. But how big should that emergency fund be?

While there's no one-size-fits-all answer, some financial analysis and planning can help you develop an emergency fund goal that's big enough to see you through tough times (but not so big that it ties up capital you need to invest in future growth).

Here are three steps to take to best estimate the ideal size of your business emergency fund.

Step 1: Calculate your monthly expenses.

The amount you need in your emergency fund depends on how much you spend on necessities each month -- things like payroll, rent, utilities, insurance, transportation, software, and other necessary subscriptions. You don't need to include any costs you'd cut from your budget in the event of an emergency, such as meals and entertainment or non-essential business expansion spending.

Knowing these numbers can help you figure out how long you can expect your funds to last if your business wasn't bringing in any revenue.

Step 2: Consider your personal finances.

One of the big questions you need to answer in calculating your monthly expenses is whether or not you would need to continue to pay yourself if faced with a financial emergency.

The answer is a very personal one and depends on your situation.

If your family depends on your business income to pay your mortgage, school tuition, and other important expenses, your business emergency fund needs to be high enough to continue paying yourself through a cash-flow shortage.

On the other hand, if you have a partner with a stable job that isn't connected to the business, you might be able to get by on less for a while.

Step 3: Determine how much reserve you need.

One common rule of thumb is to have enough cash on hand to cover three to six months of expenses.1 However, that guideline may be more than some companies need and far less than others require.

To decide how much you need, consider how long it would take you to bounce back if you suddenly lost your main source of revenue. For example, if a fire or natural disaster destroyed your business tomorrow, how long would it take you to find a new location, rent or buy new equipment, and restore operations?

Or what if the economy were to slip into a recession? How much of a hit would your business income take? If your business withstood a previous recession, you can review your old numbers to determine how much your business revenue fell before -- and also how much you ended up short until the economy turned around. This will help you estimate how much you should have in reserve to withstand a future recession.

By thinking through different risk scenarios, you can arrive at how much cash you need for each, and ultimately, how much cash you should aim to have in your business emergency fund.

The idea of stashing money away in the off chance that it might come in handy someday may seem a bit inconvenient. But having a solid emergency fund can be the key to helping your business stay afloat for the long run.