As the CFO of your small business, the first item in your job description is “Get the capital your business needs”.
Every small business—new and existing—must manage the capital of their business.
Your business requires working capital just to stay in business beyond what was necessary to start your business.
You can actually grow yourself out of business because the more successful your business is, the more capital your business will need.
Why is that?
Capital, blended with your business’ operating cash flows, becomes the financial fuel your business uses to:
- Buy plant & equipment and vehicles
- Fund business growth by purchasing stock (inventory)
- employing staff and financing debtors (people that owe you money)
- Provide reserves for both planned and unforeseen expenses. It’s a crying shame if your business has great potential but is unable to realise it, just because you don’t have the funds to hire that extra person, or get that higher capacity machine, and so on.
Under-capitalised businesses never reach their full potential.
Understanding the capital sources of your business, how to determine your business’ current and future capital requirements and how to manage and allocate these sources appropriately will allow your business the freedom to grow without financial constraints.
3 sources of small business capital / funding
1. Investment Capital
This capital / money comes from you (or another investor / partner of yours). You don’t get this capital back until you eventually sell the business or your share in it. Typically this amount is relatively low number on the balance sheet for most small businesses.
2. Retained Earnings
This is the profit your company has made that you have left in the business. For example, the profit you didn't take out as salary, bonus, dividend, or other distribution. Of all the forms of capital your business could have, this is the best kind, because your business got it the old fashioned way… it earned it.
Your bank will like seeing retained earnings on your balance sheet, perhaps even more than investment capital, because it says two things:
1) Your business has the ability to produce retained earnings by operating profitably;
2) As the owner, you had the discipline to leave this capital in the company instead of drawing it out. Excess drawing is sometimes a reason there are capital issues in a business.
3. Borrowed Funds
This is plain old debt; money you borrow from a bank. Debt can be an excellent source of capital for your business.
But there are two annoying details about debt / borrowed money:
Unlike investment capital or retained earnings, debt accrues interest which must be serviced (as in loan repayments), which creates an incremental drain on your business’ liquidity; and
Your business has to be able to generate the cash flow to make these payments.
How to determine your business’ capital requirements
First, you must know how much you're going to sell and how much you're going to purchase. Purchases could be for inventory, operating expenses, plant & equipment and owners drawings or dividends.
Then you have to estimate how long it's going to take you to collect what you sell (your debtors), and how quickly you're going to have to pay for what you purchase.
All of this has to be plotted out on a financial operating timeline: a cash flow budget.
Along this timeline / budget, any negative numbers at the bottom are cash shortfalls. These represent your capital needs and when you need it.
Tips on allocating your capital
Don't deplete operating cash to purchase large capital items.
Don't borrow money for operating expenses.
Funding receivables and inventory arising from growth with borrowed capital is not a bad plan, but establishing a long-term goal of being able to fund growth more from retained earnings and less from debt should be Part B of your plan.
Managing your debtors (days) and inventory levels is important as the mismanagement will require funding and either eat into your operating cash (retained earnings) or require debt funding or good old plain capital from you. (The Dashboard). Every dollar of profit you leave in your business as retained earnings is a step toward financial security. Retained earnings are the working capital that you don't have to borrow from the bank. It's your safety net during the inevitable period(s) of slow sales or other problems that can affect a small business.
So, if retaining earnings are such a good option, why would anyone ever invest money or borrow for capital needs of a business?
Unfortunately for most us in small business, accumulating working capital through retained earnings is a slow process. Most of us need growth capital faster than profits will generate retained earnings. The best plan is to maximise the good aspects, and minimize the bad, of all three kinds of capital in your business.
The key is to get the mix of capital right.
Determine your business’ capital requirements – prepare a good old fashioned cash flow budget. We can help you with this. Don’t purchase large capital items with operating cash. Fund with debt, however understand the cash flow impact of repaying the debt. Don’t borrow money for operating expenses even though sometimes funding receivables and inventory is not a bad plan. Again, just be certain that you understand the cash flow impact of repaying the debt.
Manage your debtors (days) and inventory levels to ensure you don’t over capitalise in these. You should not be an unpaid bank to your customers.
Making sure your business has enough, and the right kind, of capital to operate effectively and grow is arguably the most important assignment you have as the CEO of your business.That’s why all great CEO’s have great CFO’s by their sides, advising them.