How Do You Figure Out How Much Cash a Company Needs?

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Business capital is the most critical component that fuels your company and keeps it safe from the sharks in the banking world. Without it, organizations can’t grow. Whether you are scaling fast on the back of strong sales or bootstrapping your startup on a shoestring, the same operational question sits underneath every decision you make about spending, hiring, and expansion.

Ask yourself a blunt question: do you actually know how much cash your company needs to run and to grow? Most owners answer by feel, watching the checking account rise and fall. That works until it doesn’t. So how do you figure out how much cash a company needs, and how much business capital do you need to hold in reserve?

What Is Business Capital and How Much Do You Need?

Business capital is the money and financing your organization uses to fund day-to-day operations, buy assets, and pay for the growth in sales you are chasing. There are two main processes at work in any organization: capital planning and working capital management. Capital planning looks forward at how much cash future growth will demand. Working capital management handles the cash moving through the business right now. Let’s look at how the capital planning process works, starting with the habit most small organizations fall into.

Checkbook Accounting

The most common form of working capital management is what many refer to as checkbook accounting. In other words, if you have money in the checking account then you can write a check to cover the expenses, and if you don’t, then some payable is going to be put off until next week. Sound familiar?

While this might be how many small organizations execute financial control, and perhaps how many individuals manage their own finances, it is not an effective way to manage your business finances. The opposite can also be true. Cash can pile up in your checking account faster than you can spend it, which is its own kind of problem because idle cash earns nothing. So, at some point we have to start planning our capital strategy, which begs the obvious question: how much business capital do you need? Before you can answer it, it helps to understand the financing options the U.S. Small Business Administration outlines for funding a business, from retained earnings to debt to outside investors.

Small business owner reviewing bank statements and a checkbook ledger with a calculator at a desk

Business Capital Needs Analysis

Your company capital needs are based on your revenue growth and your cash flow situation. Revenue growth comes from increasing the sales of your products or services, which in turn requires increases in expenses, assets, and working capital to fulfill those sales. This may seem obvious, but what is not so obvious is that there is a ceiling to this growth. Your growth is limited to your equity growth.

Two finance managers reviewing a printed balance sheet with equity and debt figures at a table

Growing Equity

Equity increases either as a result of adding to retained earnings, which comes from your profits, or by asking investors to invest in your business. Here is where profit becomes important. Since profit is taxable, many owners would prefer to report as little profit as possible in order to reduce their taxes. Profit, however, adds to retained earnings to create equity growth and allow for increased debt capacity via your debt-to-equity ratio. We need profit to fuel future revenue growth, and profit is what is demanded by investors.

If your revenues are growing faster than your equity, then your assets must be growing too, and since assets = liabilities + equity, then your liabilities must be growing faster than your capacity to pay for those liabilities, which is your equity. Therefore, your equity equals your capacity for growth. If you do not grow your equity in line with your revenues, then you will be running out of cash and be forced to raise capital at the worst possible moment.

Debt-to-Equity

The first choice for many may be debt, but your debt load is bounded by both your debt-to-equity ratio and your Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), or cash flow. Your credit policy protects your business cash. Offer too lenient terms to your customers and you could end up with a risk asset in your accounts receivable rather than cash in the bank.

Your debt-to-equity ratio is calculated by dividing your debt by your equity. A ratio of one or less is considered good, whereas ratios greater than one start to increase the lender’s risk. Risk tolerances vary by industry, so there is no golden rule above one. A capital-heavy manufacturer and a lean services firm can carry very different ratios and both be healthy.

Operating Cash Flow or EBITDA

You can only borrow debt up to your ability to make debt payments with your operating cash, so your debt is bounded by your EBITDA, which is a measure of your operating cash before financial expenses like interest, tax expenses, or depreciation (amortization or depletion). Since depreciation and amortization are non-cash expenses for tax purposes, EBITDA represents the raw cash produced by the operating business.

Note that interest is usually a deductible expense, so as you increase your debt, you also increase your interest expense, which lowers your taxes paid. That tax shield makes moderate debt cheaper than it first appears, but it never removes the hard ceiling that operating cash flow places on how much you can safely borrow.

Profit Drives Growth

We have seen how profit is used to drive growth, which is one aspect of your cash needs. The other side is based on what you are going to do with the cash. You can purchase assets, use it for other expenses, hold it, pay down debt, or give it to the shareholders. Think of spending cash as investing, and investing is about understanding the Return On Investment you are about to make. Remember, your cash is only as secure as your internal controls for cash security.

Accountant working through operating cash flow and EBITDA figures on paper with a calculator

Figuring Out How Much Cash a Business Needs

Having too much or too little cash can both be detrimental to your organization. Too little and you cannot fund growth or absorb a bad month. Too much and idle capital sits earning nothing while investors ask why. You don’t have to be a CFO or finance expert to understand how cash flow works within your company, but it certainly helps to run the capital planning and working capital numbers on a regular schedule rather than by instinct.

Put simply, your capital needs are a function of how fast you are growing, how much equity you have built, how much debt your EBITDA can service, and how disciplined your controls are. Download Free Policies and Procedures to see how easy it is to edit MS Word templates and build your own financial policy and procedure management system.

Frequently Asked Questions

What Is Business Capital?

Business capital is the money and financing a company uses to fund operations, purchase assets, and pay for the growth in sales it is pursuing. It comes from retained earnings, debt, and investors, and it is the fuel that lets an organization grow safely.

How Do You Figure Out How Much Cash a Company Needs?

Your capital needs are based on your revenue growth and your cash flow situation. Estimate how much your expenses, assets, and working capital must increase to fulfill expected sales, then compare that requirement against the equity you can grow and the debt your operating cash can service.

What Is a Good Debt-to-Equity Ratio?

The debt-to-equity ratio is calculated by dividing your debt by your equity. A ratio of one or less is generally considered good, while ratios greater than one increase the lender’s risk. Risk tolerances vary by industry, so there is no single golden rule above one.

Why Does EBITDA Matter for How Much a Business Can Borrow?

You can only borrow debt up to your ability to make debt payments with operating cash, so your debt capacity is bounded by your EBITDA. Because depreciation and amortization are non-cash expenses, EBITDA represents the raw cash the operating business produces to service that debt.

How Does Profit Drive Business Growth?

Profit adds to retained earnings, which grows equity and expands your debt capacity through the debt-to-equity ratio. Since your growth is limited to your equity growth, sustained profit is what fuels future revenue growth and keeps you from being forced to raise capital under pressure.