The Rainy Day Ledger: Working Out How Much Cash Your Business Should Really Hold in Reserve

Ask ten business owners how much cash they keep in reserve and you will receive ten different answers, most of them guesses. Some hold three months of costs because a book once told them to. Others hold nothing at all and treat the overdraft as the buffer. Neither approach is a plan.

At Pomfrey Accountants, we prefer a formula to folklore. The right reserve depends on how your income arrives, when your bills fall due, and how quickly you could tighten your belt if the phone stopped ringing. Here is how to work it out properly.

Start With Your True Monthly Burn

The foundation of any buffer calculation is your monthly running cost — but not the figure on your profit and loss account. What matters is cash out, not accounting cost.

List everything that leaves the business account in an ordinary month:

• Salaries and PAYE, including your own drawings if you are a sole trader or director
• Rent, rates and utilities
• Supplier and subcontractor payments
• Insurance, software subscriptions and professional fees
• Loan repayments and finance agreements
• A realistic allowance for VAT (more on this below)

Exclude depreciation and other non-cash items — they do not empty the bank account, so they do not belong in a cash calculation. What you are left with is your burn rate. If the total is £6,400 a month, that is the number everything else builds from.

The Three-Layer Buffer

Rather than one vague number, we recommend thinking of your reserve in three layers, each answering a different question.

Layer one: the trading cushion (one to two months of burn). This covers ordinary turbulence — a client paying fifteen days late, a supplier invoice arriving earlier than expected, a quiet August. Without this layer, every small wobble becomes a crisis.

Layer two: the tax reserve (one to two months of burn, depending on your position). VAT, corporation tax and Self Assessment bills do not care about your cash flow narrative. A sensible rule of thumb: if you are VAT-registered and profitable, set aside roughly one month of burn to cover the gap between collecting VAT and paying it over, plus whatever corporation tax accrues each quarter. Businesses that hold tax money separately rarely face the January scramble.

Layer three: the contingency fund (two to three months of burn). This is the serious money — for losing a major client, a market downturn, or a personal emergency that pulls you away from the business. The size of this layer depends on how concentrated your income is. A business with one client providing 60% of revenue needs the full three months. A business with two hundred customers can lean towards two.

For most established small UK businesses, the sum lands between four and six months of burn. A brand-new business with irregular income might reasonably hold more; a business with contracted, recurring revenue can hold less.

Adjust for Your Season and Your Terms

Two factors can push your buffer well above the standard range.

Seasonality. If your trade is concentrated — a garden centre in spring, an accountant in January, a heating engineer in December — your reserve must bridge the lean months entirely. Map your last three years of monthly income. If any three consecutive months generate less than half your average, those months must be fully funded from cash, not optimism.

Payment terms. A business paid on seven-day terms can run a thinner buffer than one invoicing large corporates on sixty days with no guarantee they will honour them. Add half a month of burn for every ten days beyond thirty that your average customer takes to pay. If your debtors average seventy days, that is an extra two months of costs you must fund in the meantime.

A Quick Stress-Test Worksheet

Work through these five questions and total the months:

1. Base cushion: one month of burn, plus one more if income fluctuates month to month. (1–2 months)
2. Tax position: one month if VAT-registered and profitable; add one more if a large corporation tax or Self Assessment bill falls in a weak trading quarter. (1–2 months)
3. Client concentration: add one month if any single client exceeds 30% of revenue. (0–1 months)
4. Payment terms: add half a month for every ten days your average collection period exceeds thirty days. (0–2 months)
5. Seasonality: add one month for each consecutive lean month you identified in your income history. (0–2 months)

A typical result sits between three and eight months. If your total is above eight, you are likely holding more cash than you need — which brings us to the next question.

Where to Keep the Money

A buffer should be safe and reachable, not buried in the current account earning nothing. Three options worth considering:

• An instant-access business savings account for layers one and two. Rates on these accounts are materially better than most business current accounts pay, and the money is available within a day.
• A short-notice or easy-access account for part of the contingency layer, accepting a few days' notice in exchange for a better rate.
• A pre-agreed overdraft facility as a final backstop rather than a first resort. It costs little or nothing while unused and can cover a genuine short-term gap — but relying on it routinely is a warning sign, not a strategy.

Keep the layers in separate accounts if you can. Watching the tax pot sit untouched is the single most effective discipline we know for preventing it being quietly spent.

Review It Annually

Your burn rate changes, your client list changes, and tax thresholds move. Revisit the calculation each year — ideally shortly after your year-end, when the full picture is fresh. If the arithmetic feels like more than a quick job, that is precisely the sort of thing we help clients with at Pomfrey Accountants. A well-sized buffer is not caution for its own sake; it is what lets you make decisions from a position of strength rather than panic.