Ask the owner of a profitable business whether it has reserves, and the answer is usually yes: there is plenty of cash in the bank. Ask how much of that cash is a reserve, and the answer gets less certain. Some of it is next month's payroll, some is a tax payment due in the spring, and some belongs to a supplier who will be paid on the thirtieth. What remains is whatever happens to be left, and it changes every week.
Most owners would call that a reserve, and a yield buyer would not. To the buyer, a reserve is cash set aside under a rule, for a stated purpose, and spent on nothing else. A business without one funds its first bad quarter by cutting the payout or by borrowing, and either tells the buyer that the payout was never as reliable as it looked.
Reserve Policy creates the real thing. It moves free cash flow to equity less reserves by taking funded reserves off under a written rule before anything is called distributable, so the figure a yield buyer capitalizes is what is left once the business has protected itself.
Where Reserve Policy sits
Three drivers decide what stays in the business before anything is called distributable. This essay covers the first.
Free cash flow to equity
- Reserve PolicyThis essayDeducts funded reserves under a written rule before anything is called distributable
- Reinvestment FloorTests capital spending against a floor set from the asset register; only a shortfall comes off
- Retained GrowthGoverns cash held back for growth: its return reported, its stance stated, its end date written
FCFE less reserves
A rule, sized from the business's own record
The rule is written down and adopted by the board, and it has three parts. An operating reserve covers the fixed operating costs of a hard stretch together with the scheduled debt service falling due over the coming quarters. A capital reserve is funded from the replacement schedule. And a refill rule restores any draw before the next distribution is declared.
The operating reserve is sized from the closed statements. Fixed costs come from the last few years of closed accounts, the worst quarter in that period is identified, and the reserve is set at whichever is larger: the formula, or the cash that worst quarter actually lost. The second test exists because a formula is an average, and businesses fail in particular quarters. If the worst quarter on record lost more cash than the formula would hold, the reserve has to be big enough to have covered that quarter.
Sizing the operating reserve
Illustrative. The operating reserve holds a number of months of fixed operating costs plus a number of quarters of scheduled debt service, or the worst quarter's cash shortfall over the last few years, whichever is larger. The months and quarters are the illustration's own choice. Raise the worst quarter past the formula and it sets the reserve.
The capital reserve does a different job. It is there for replacements the business can see coming. It is funded every month from the replacement schedule built under Reinvestment Floor, so that when a large asset reaches the end of its life, the cash to replace it is already there. A business without one pays for a new roof or a new machine out of whichever quarter the bill lands in, which is how a payout gets cut in a year that was otherwise fine.
The refill rule comes next. A draw on either reserve is refilled from free cash flow to equity before any further distribution, and the policy states the longest period a reserve may stay below its floor. The whole rule then goes to the board for adoption by resolution, attached to the distribution policy, so that only another resolution can change it. With the rule on paper, a buyer can compute what is set aside before it looks at what is paid out, and the discount it would otherwise take for not knowing shrinks.
Held apart, where one person cannot move it
The rule then has to be met in cash. Both reserves are held at or above the rule, in accounts separate from operating cash, at every quarter-end for a sustained run before the first distribution under the policy, and at every quarter-end since.
The accounts are opened with dual authorization. A withdrawal needs the finance lead and one other signatory, so the owner alone cannot move reserve cash. The reserves are funded on a schedule ahead of any payout, with a fixed monthly transfer until the floor is reached, and the owners agree in advance to a period of reduced or paused distributions while that happens. Every month the reserve balance is reported against the rule, along with any draw and refill. This is the part a buyer can verify from a bank statement, and it is what lets the buyer treat the protection as lasting.
The funding period is the hardest part of the driver for owners, because it costs them money they are used to receiving. A business building an operating reserve of $850,000 from free cash flow of $600,000 a year may pay its owners little or nothing for a year or more. That is why the owners' written agreement to the funding period comes before anything else. A reserve the owners have not agreed to fund will be raided the first time they press for a payout.
A test before every distribution
Every distribution's file shows both reserves at or above the rule once the payment is made, and the reserve test that proves it is the first line on the distribution checklist. The finance lead computes the balances that will remain after the proposed payment and signs the test before the board sees the proposal. If the payment would take either reserve below its floor, the proposal is cut or deferred on the way to the board, so the board never has to argue down a payment it has already been shown.
A draw, and the refill
A reserve exists to be drawn on, and the first draw is when the policy is really tested.
A draw and the refill
Illustrative. The operating reserve at each quarter-end, above or below its $852,000 floor, the illustration's own; a dashed bar is a quarter below the floor. A draw in Q4 takes it under; the refill rule pauses distributions until it is restored.
Operating reserve above or below the floor, thousands of dollars
The reserve stood below its floor at the ends of Q4, Q5 and Q6, and no distribution was declared in those quarters. It was back above the floor at Q7, inside the refill period the policy states, and distributions resumed.
Show the numbers
| Quarter | Operating reserve above or below the floor, thousands of dollars |
|---|---|
| Q1 | $8k |
| Q2 | $18k |
| Q3 | $28k |
| Q4 | −$242k |
| Q5 | −$152k |
| Q6 | −$62k |
| Q7 | $8k |
| Q8 | $28k |
In the illustration, a business holding its operating reserve just above its $852,000 floor draws $270,000 in a quarter when a large customer delays payment and revenue falls. The reserve drops to $610,000, below the floor, and the refill rule stops the next distribution. Over the following three quarters the reserve is refilled from free cash flow to equity, and distributions resume only when it is back above the floor. The owners received less for three quarters. A yield buyer would not read that as the payout failing, because the policy had said in advance what would happen, and it did.
What it does to value
Reserve Policy ranks sixth on the bridge, and it lowers the figure a buyer capitalizes. Every dollar contributed to a reserve is a dollar not distributed.
What the owners get for it is protection, and the valuation counts protection in two places. It lowers the probability and the size of a payout cut in the downturn scenario, valued as the distributions that scenario would have cut, discounted over the expected holding period. And it steadies coverage, which narrows the coverage-variation component of the holding-period premium a holder requires. The cost of the contributions over the holding period is taken off. For most businesses the result is positive, which is why the driver is worth doing, but it is a smaller number than owners who think of reserves as pure safety expect.
What has to be in place first
The reserve needs an owner inside the business, and that is the finance lead who owns treasury: the person who prepares the reporting pack also holds the reserve accounts and the distribution checklist. It needs the owners' written agreement to a funding period, since the reserves are built from cash that would otherwise have been paid to them. And where the credit agreement touches cash, it needs the lender's consent. A cash sweep, a restricted-payment clause or an account control in the facility can limit how reserve accounts may be held, so counsel checks before the accounts are opened.
Knowing that it works
Each month the operating reserve, in months of fixed cost, is reported against the floor. The count of consecutive quarter-ends with both reserves at or above the rule should reach a sustained run before the first distribution under the policy. And after a draw, the days the reserve stays below its floor are set against the refill period the policy states.
With the bank statements and the checklist, the owner should be able to recompute the last reserve test and reach the same balances without the finance lead's help. And asked what happens to the reserve and the payout if revenue falls sharply next quarter, the owner should answer from the written rule, without reaching for instinct.
Why it slips, and what holds it
The decay this driver guards against is reserves drawn to fund the payout and never refilled. It usually happens in a good year, when the owners want a larger distribution and the reserve looks bigger than it needs to be.
The safeguards make that impossible to do quietly. The refill rule is part of the adopted policy, so a reserve below its floor stops the next distribution by rule, and a draw cannot become permanent without a board vote to change the policy. Dual authorization on the reserve accounts means no one person can move reserve cash to fund a payout, so every draw is a recorded decision.