Monday 4 February 2013

Something in reserve?

Reserves, retained profits, net assets, shareholders' funds. All are measures of what is left in a company after allowing for any liabilities. In other words, it's the surplus of assets - plant & machinery, stock, debtors and cash over liabilities - creditors, tax due, loans etc.

So why are reserves important? Well as the name suggests they are a bit of a contingency. Something for a 'rainy day'. Something to fall back on if trade and profits dip or to invest for future growth. In my experience, many small business owners don't pay enough attention to reserves (or the lack of them). Often they are focused on profits, cash flow and their own income - all of which are important. Building reserves or 'strengthening the balance sheet' as it sometimes referred to is arguably a more complete measure of how a business is performing and how it is evaluated by external parties. Weak reserves affect a company's credit rating so there is a tangible cost in not addressing this issue.

So what is a healthy level of reserves? The answer will depend to some extent on the maturity of a business, the sector, the shareholders' objectives and so on. For a mature business I would suggest that reserves equal to one month's average turnover should be a minimum. A more reasonable reserve might be around 3 months turnover. So a strong business with annual sales of £1m might have reserves of £250k. This business would be well placed to cope with sudden changes in circumstances. A weaker business with minimal or no reserves may be fatally wounded if it suffers a sudden fall in turnover or a cash flow crisis.

So if you are setting targets for your business you need to consider sales, profits and cash flow but think too about reserves. This means taking a cautious view of dividends and drawing no more than the business can afford. Building reserves takes focus and discipline but It could help your business stay around for the longer term.

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