Dennis BeaverJuly 17, 2020 • By Dennis Beaver  

“We have all heard of the importance of a ‘Rainy Day Fund’ for such things as being out of work for a period of time or facing an expensive car repair, ‘Amy’ wrote. “But I have never heard of anything similar for a business and wonder if you could provide some guidance for me and my small architectural firm.”

Prepare for and Expect the Unexpected

I ran Amy’s question by a friend of this column, Bakersfield-based Douglas Payne from Morgan Stanley. He works closely with small business owners and holds an Accredited Investment Fiduciary® designation.

His answer was in many ways a cautionary tale of companies that failed to, “Prepare for and expect the unexpected” financial event.  “You never want to find all your cash and working capital so tied up in, for example, an expansion program, that if things suddenly go south, you face bankruptcy.”

“Covid -19 certainly fits into that paradigm,” Payne underscores, adding, “Having a substantial rainy day fund can help your business survive the most challenging of times, and the calculation of how much you need must take into consideration:

(1) Your average monthly operating expenses over a year or so, and in view of Covid-19, experience has shown the ‘3 to 6 months’ savings often recommended for individuals may be greatly inadequate for a business. You need to come up with a worst-case scenario in order to assess a comfortable level of financial back-up.

(2) Which employees can you risk losing? Determine those key employees you need to retain and keep on the payroll, as the loss of essential staff can spell disaster. Ideally, you want to keep these people from jumping ship and the way to do that is by keeping them on the payroll as close to their normal rate of pay as possible.

(3) Do not rely on your accounts receivable to function normally, as Covid-19 has shown. You need to assume great disruptions in cash flow, and even your ability to pay bills on time. Therefore, the more in your office rainy day fund, the better.”

In What Form Should Your Emergency Funds Be Held?

 As with all investment considerations, time horizon plays a key role in that decision. Since the emergency fund is set up to cover unexpected business disruptions, one cannot usually determine in advance when that will be. In December of 2019, who could have predicted that our economy would come to a grinding halt within a few months?

“With that in mind,” Payne observes, “A money market account or very short term CD is usually the best solution, and usually, a business owner will have a banking relationship where this can be set up.

“But one should be mindful of the FDIC protection limits per bank. For deposits in excess of FDIC, simply use a bank’s CDARS service which can place excess funds into other bank CDs with their own separate FDIC coverage. Additionally, most brokerage firms have access to numerous bank CDs, all with their own FDIC insurance coverage.

“Unfortunately, in today’s interest rate environment, investors will not see much of a yield.”

In What form Should These Rainy-Day Funds NOT be held?

For most of us the temptation is always there to want higher yielding investments, and all investment houses tell us that we need an investment time horizon and risk tolerance established before deciding what investments are acceptable.

But Payne advises us to, “Take caution not to place emergency funds in investments like stocks, real estate, precious metals or low quality bonds in an effort to maximize growth or income from these emergency funds. Always bear in mind that in this case, liquidity and safety of principal must be your primary objectives. You may need this money on very short notice, so you never want access to these funds subject to a delay.

“Even a CD can be cashed in immediately, and you will only suffer, in today’s low interest rate, the loss of a small amount of interest. But at least you can access the money almost immediately, which may not be the case with more traditional investments.”

What Can a Financial Advisor do to Help Answer These Questions?

Preparing for the financially unexpected, “Is best accomplished with the help of your CPA and financial advisor who can help business owners identify significant areas of risk in the client’s financial life and then discuss risk mitigation strategies.”

The Covid-19 pandemic and regulatory response has caused a disruption of normal commercial activity across the country and left many small businesses on the brink of ruin.

“Those that survive will undoubtedly be rethinking the value of maintaining a business emergency fund in the future, “Payne concludes.

Dennis Beaver practices law in Bakersfield and enjoys hearing from his readers. Contact Dennis Beaver.