Separate Fact from Fiction: What Cash Reserves Really Mean

Cash reserves are the immediate liquid funds a company or household has available to meet day-to-day demands. This is particularly important when dealing with an unforeseen expense. Without cash reserves, a company would need to spend money that was budgeted toward other directives on items that come up unexpected. Often, this can cause a company to miss payments on debts, leading to delinquency or even potential bankruptcy. A company will list its cash reserves on a financial statement, but the numbers can be misleading.

Defining Cash Reserves

Cash reserves are very narrowly defined as actual cash in the bank. This is the equivalent of a "savings account" for a company. The money cannot be invested in other stocks, tied up in equity in the business or otherwise allocated toward payments. Because the money has been saved for a rainy day, the company should not be touching these funds in any way. A cash reserve will vary slightly from month-to-month due to small items like interest and payments, but it should remain fairly consistent. Further, the reserves cannot be in the form of debt to a bank or other investor.

Determining Significant Cash Reserves

There is little regulation regarding the amount of cash reserves a company should hold. The primary exception is a bank or financial institution. These organizations must maintain a level appropriate to meet FDIC standards in order to be considered solvent. A large company will likely have a credit rating from an institution like Standard & Poor's. This can be an indication of whether or not the company has significant cash reserves. For a small company, though, the credit rating is not always available. A good measure for an appropriate reserve would be enough to handle three months of expenses and payments without income.

Considering Assets that Could be Liquidated

For some businesses, a cash reserve may be slightly smaller if there are a number of assets that could be immediately liquidated to make payments. For example, an auction house has a number of assets that could be sold immediately, even if under their intended sale value, for cash. Real estate is often considered slightly less liquid, but a real estate investment group could liquidate if necessary. A bank, on the other hand, cannot easily call in loans in order to liquidate its assets. For this reason, a bank would need to have a higher cash reserve than a company with a number of assets to immediately sell off.

Problems with Insufficient Reserves

If a company has insufficient reserves, investing in that company could spell trouble. Most companies in the United States operate on a debt cycle. Many are formed on credit, and most take loans for purchasing, payroll and expansion. They pay this debt off with profits. If an unexpected expense, like a lawsuit or broken machinery, requires immediate payment, profits must be allocated here instead. This means loans would go unpaid without cash reserves. The business could lose value quickly and go into default with lenders, resulting in bankruptcy for the business and lost dollars for any investor.

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