Independent consultants, do you have cash reserves large enough to be able to do without any business for six months? If not, Chip Camden explains why it's prudent to set aside funds.
Running your own consulting business requires cash. Unlike employees — whose initial cash outlay typically consists in transporting their bodies, reasonably clothed, to work the first day — independent consultants usually have to provide their own equipment, workspace, software, business license, and a whole host of other expenses before they can collect their first dollar, euro, or yen. Additionally, we have to keep a certain amount of cash available at all times to meet recurring or unexpected expenses and to stay afloat through the famine phase of the feast or famine phenomenon.
Ideally, you should have cash reserves large enough to be able to do without any business for six months. That would allow you to develop exactly the kind of business you want, which would likely result in making more money in the long run. Why do the rich get richer? It's because they have the luxury of deciding how they will use their money. By contrast, most people have already committed most of their income and often all of their reserves, which severely limits their choices for new ventures.
Besides this fund for anticipating the unexpected opportunity or the inevitable rainy day, you should also put aside funds for known, recurring expenses that are too great to take in stride. For instance, in the USA, most independents must pay their taxes on a quarterly schedule. The tax bill for an entire quarter would probably break a monthly budget, so you need to prepare for that expense by saving a portion each month to avoid getting behind. Oh, if you do get behind, you'll find that the IRS will politely avoid mentioning it. They'll gladly assess penalties and interest after the fact that would make putting the balance on a credit card a (not much) better choice.
Another big ticket item is software licenses. I try to use free software for most things. I've found that a good open source community often produces a better product and provides better support than their high-priced, closed counterparts. But some clients insist on certain brands. In my business, for instance, I can't afford to ignore Microsoft. So the annual MSDN Subscription renewal is another expense I have to incorporate into my plan, however much it makes me grumble.
Regarding hardware purchases, it's not too hard to plan for upgrades. You can usually see those coming. But we often forget to plan for failures. We're fortunate to live in a time when the price of a disk drive makes it something you can afford to keep on your shelf, or replace just because it's getting a little old. If you wait for disaster to strike (and eventually it will), you'll spend a lot more time responding to the situation. Invariably, your time costs more when it's demanded unexpectedly. Not only do you waste more time because you didn't plan for the event, but you might miss other opportunities in the process.
So, all of you smart consultants have at least $100,000 in ready cash, right? In my 20 years as a consultant, I have never even come close to that. And with the economy doing what it's doing (or rather, not doing) I don't see myself getting to that ideal situation any time soon. I don't think I'm alone here. If you're in the same boat, then you have to sort out your priorities and develop a contingency plan.
The one thing you don't want to do is to immediately jump down the credit card hole. It takes a long time to climb back out. Worst of all, it costs more money. That's the problem you're trying to solve, not make worse. If you keep going down that path, pretty soon you're shelling out hundreds of dollars a month just for the privilege of having used that money in the past.
You can effectively use a credit card for smoothing cash flow, as long as you know that you will be able to pay it off soon. For example, if you need to travel on business, your client might take a month or so to reimburse you. You can charge those travel expenses, so long as you turn around and pay them when you do get reimbursed.
You can also use a credit card as a poor man's excuse for the Rainy Day fund. But be careful. Two or three unexpected hits in a row, and you could easily find your credit balance spiraling out of control.
With any loan on interest, you need to evaluate the total cost of that loan and compare it against the benefit you'll receive from those funds. Don't take out a business loan to grow your operations unless you can anticipate that the interest expense will be more than offset by increased revenue at some point. Otherwise, you're just blowing money on your hobby.
Even if you can't maintain it, it's still good to have an ideal cash situation in mind. That tells you what you need to do with the extra funds when you get paid for that big job. Don't blow it on a new car or an expensive vacation if your cash reserves are scraping bottom.