How Much Business Capital Do You Need?
Business Capital is one of the most critical components that fuels your company. Without it, organizations can’t grow, but how do you know how much your business really needs? Having too much or too little cash can both be detrimental to your organization. You don’t have to be a CFO or finance expert to understand how cash flow works within your company, but it might help.
There are two main processes at work in any organization: capital planning and working capital management. Let’s look at how the capital planning process works.
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, 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. So, at some point we have to start planning our capital strategy, which begs the obvious question “How much business capital do you need?
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.
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 would prefer to report as little profit as possible in order to reduce their taxes. Profit, however, adds to retained earning 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 you 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, i.e. your equity. Therefore, your equity equals your capacity for growth. If you don’t grow your equity in line with your revenues then you will be running out of cash and be forced to raise capital.
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 Earning Before Interest Taxes Depreciation and Amortization (EBITDA) or cash flow.
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 starts to increase the lenders risk. Risk tolerances vary by industry so there is no golden rule above one.
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.
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.
Profit Drives Growth
We have seen how profit is used to drive growth, which is one aspect to 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.
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