How to calculate capital needs - planning working capital for business corporations

Nation's Business, Nov, 1989 by Mark Stevens

How To Calculate Capital Needs

Puzzled about how much your firm should borrow? Try these guidelines to come up with a figure.

It's the Rubik's Cube of business management. You know your company needs capital--money for raw materials, promotions, inventory, and payroll--but you're not certain just how much cash you'll need over the coming months and years. No matter how you twist the puzzle pieces, the answer escapes you.

You're not alone. When it comes to borrowing money or arranging credit lines, CEOs know they need enough to grow the business and see it through sluggish periods. The question is: How much is enough? How do you account for ongoing needs, for seasonal requirements, for the unexpected?

"You do it by studying your company's business cycles," says small-business adviser Herbert Schechter, a certified public accountant and partner in the Minneapolis office of the accounting firm of Laventhol & Horwath. "This reveals when and why you need cash, and that becomes the basis for your borrowing strategies. Most important, you calculate the flow of cash out of the business for inventory and the other costs, and then compare this to the time it takes to recover that money through the collection of receivables. What you're looking for is sufficient working capital to close the gap between disbursements and collections."

If you have traditionally based your cash projections on gut instinct and seat-of-the-pants estimates, chances are that you have come up short when your company could least afford it. To prevent this crisis-to-crisis method of financial management, Schechter says, try bringing some science to the critical task of projecting your company's capital requirements. The approach outlined here uses information from your company's financial statements:

* Determine your collection period. For simplicity's sake, assume that your annual sales are $365,000. Dividing this figure by the number of days in the year gives average daily sales of $1,000. If your accounts receivable balance is $60,000, you have a collection period of 60 days.

* Perform a similar calculation for inventory. Suppose your cost of goods sold is $220,000. Dividing this by 365 gives daily costs of about $600. If your inventory is $27,000, then you have 45 days of inventory on hand.

* Now proceed to accounts payable. Assume you have annual purchases of inventory and raw materials of $182,000 per year. Divide this by 365 days, and you have purchases of approximately $500 per day. If your accounts payable are $16,000, you have an accounts payable period ($16,000 divided by $500) of 32 days. This means it takes about a month to pay your bills.

* The next step is to take the total of accounts receivable and inventory days (in this case, 105 days) and subtract from this the accounts payable period (32 days), leaving a net of 73 days.

"With this process, you've calculated the company's trade cycle," Schechter says. "The purpose is to figure how much working capital the company requires, and that's what it does.

"Assume your annual cash needs (sales minus profits minus such non-cash charges as depreciation) are $340,000 a year. Because the company's 73-day business cycle is about 20 percent of a year, you need about 20 percent of $340,000, or $68,000 in working capital credit. While this can be reduced by existing lines of credit or by profits plowed back into the business, it's a good estimate of the company's cash requirements."

This simplified calculation can be fine-tuned for your company by developing more detailed information on cash flow. This is usually done on a monthly basis, since most businesses collect from customers and pay suppliers monthly.

The cash-flow forecast should be comprehensive, and it should encompass cash sources and outlays, including revenues, proceeds from the sales of surplus fixed assets, disbursements for new equipment, income-tax payments, loan payments, dividends or withdrawals, and deposits on merchandise for future delivery.

Cash receipts and disbursements do not always balance out. Large cash inflows come shortly after customers are billed. Large cash payments must be made to build inventory, buy equipment, or pay taxes.

Capital-planning calculations, says accountant Schechter, "bring into sharper focus the company's cash needs, taking some of the guesswork out of the borrowing process. And they help convince bankers that you not only need loans but will be in position to repay them."

Business columnist Mark Stevens is the author of Sudden Death: The Rise and Fall of E.F. Hutton.