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Estimating capital needs
Whether you launch a new business or take over an existing one, you will need to estimate how much capital your company will need. A business plan is helpful in planning your capital requirements.
Capital requirements depend on the sales goals you set for your business. At a lower level of sales, capital requirements are usually lower than at higher sales levels. As you increase sales, it is necessary to invest in additional
fixed assets and staff to attain the higher goals. Capital required for these investments is called investment capital.
For example, you may estimate that you need to hire an additional account manager and one piece of additional manufacturing equipment, at a total cost of $75,000, for each $250,000 in higher forecast sales. Unless you have accumulated enough in profits, you will more than likely turn to outside sources—a bank or potential investor— to raise capital. (If you're seeking a new source of funds, including a copy of your latest business plan increases your chances of success.)
In addition to investment capital, you may find that you business requires additional net working capital until it generates enough in cash each year. Working capital is equal to your current assets minus current liabilities. Both of these totals are shown on your company balance sheet.
Current assets are assets that are in cash or can be converted to cash within a year, including cash and investments, accounts receivable, and inventory. Current liabilities are those liabilities you expect to pay with cash over the next year. Accounts payable and deferred income taxes are current liabilities.
The ratio of current assets to current liabilities is called the working capital ratio. The working capital ratio is a key indicator of the liquidity of your business. Prospective lenders and investors will evaluate your working capital ratio when considering your request for funds:
A working capital ratio of 1.0 means that current assets equal current liabilities. A ratio of 2.0 means that current assets are twice as large as current liabilities.
A ratio of less than 1.0 will likely raise a red flag to a prospective lender since it suggests you owe more than you have available in the near term. Depending on your industry, a certain working capital ratio might be considered normal. For example, a ratio of 1.3 to 1.5 may be normal for a retailer but too low for a manufacturing firm. As long as your working capital ratio is in line with those of other companies in your industry group, you can breathe easier.
Underestimating your investment capital needs may require you to cut back on a sales forecast. After all, investment capital pays for the additional capacity you need to meet sales growth. If you underestimate your working capital needs, you face a liquidity crunch and will likely need to raise funds quickly. For this kind of short-term fix, small businesses often rely on a line of credit from a bank. Absent a line of credit, you may find yourself, as owner of the business, paying expenses with a credit card or other expensive form of debt.
For example, you may calculate that you need $50,000 in working capital but revise your estimate upward to $100,000 a few months later. To minimize the risk of underestimating your capital needs, it helps to review your estimate carefully and have a line of credit in place with a lender. It also helps to have an experienced finance and accounting staff—a second set of experienced eyes—to identify potential shortfalls in capital.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: Obtaining enough capital
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