Want to be cash-ready for financial emergency? Follow these rules

Different levels of saving are called for because of the varying levels of uncertainty that exist
According to the Reserve Bank of India's annual report, household savings in cash have risen to a peak level of 2.8 per cent. While households must have an optimal level of cash to meet their day-to-day requirements and emergency needs, holding too much cash can be detrimental for their financial health as cash in bank or liquid funds earns a lower level of return than in other instruments like equities.  

Ideally, one should have one month of expenses as cash on hand. This money in the house will help you deal with emergency situations like the recent flood in Kerala, where people had money lying in their bank accounts but could not access them, because the ATM machines and bank branches were not working. It will also prove useful in dealing with health emergencies. This money should be kept at home in a secure place, such as a locker, and the whereabouts of the key should be known to more than one person.

Households also need to maintain a contingency fund. The amount of contingency fund you maintain should depend on the structure of your family. "If you are a double-income family, you should have three months of expenses in the contingency fund. One month of expenses may be kept in cash at home and two months may be kept in a savings account or liquid funds (1+2). If you are a single-income family, you should have a 1+5 saving structure, while entrepreneurs should maintain 1+11 savings," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Different levels of saving are called for because of the varying levels of uncertainty that exist. If you are from a double-income family, the chances that something happens to both partners - both fall ill or lose their jobs together - are lower. On the other hand, if you are single income, the risk is greater, because it is concentrated in one person. An entrepreneur can face a long delay in getting payments, but he will still have salaries to pay to his employees. Those entrepreneurs who are not well established in particular need to keep a higher level of contingency money.

Contingency funds may be kept in liquid funds, sweep fixed deposits, and ultrashort-term funds. If you have a sweep account, you don't need to keep money in savings accounts. Money above certain levels automatically gets swept into a fixed deposit in sweep accounts. Suppose that you issue a cheque of Rs. 100,000 and the balance in your savings account is only Rs. 10,000. The rest Rs. 90,000 will be automatically pulled from your fixed deposit. From the user's perspective, it is as good as a savings account in terms of liquidity, but it gives the returns of a fixed deposit (for so long as the money is lying in the fixed deposit).

Liquid funds are another good option for keeping your contingency money. Liquid funds pay out money within 24 hours, provided you apply for redemption before the cut-off time, which is 2 PM. Invest in funds that have most of their exposure to AAA-rated paper, and A-1 rated paper. Simply going by returns will not capture the risks that the fund manager is taking. Also, look for liquid funds that have low expense ratios.