NATIONAL SMALL BUSINESS WEEK 4: Appropriate Working Capital for Small Businesses 2
If you do not put up enough money for Working Capital, you will be forced to incur debt or inordinately prolong accounts payable so that you get into trouble with your suppliers. Not having adequate Working Capital will place your business in an unsustainable cycle of debt.
After you have determined the amount you need for the fixed assets you have to acquire to be able to operate, you have to add to this amount what you need for Working Capital.
To determine Working Capital:
1 find out how much it takes to produce one unit of your product
2 estimate how many units you can sell within a period, say, a month
3 determine how long and how much it takes to produce the estimated units of products for sale (include delivery time for raw materials and, to be conservative, assume that you have to pay cash)
4 estimate how long it will take to convert your goods for sale to cash (i.e., collections)
5 determine how much you need to operate, i.e., overhead or operating expenses
6 calculate the time from the delivery of materials to collection of sales proceeds
7 multiply your overhead by the length of time determined in step 6
8 Add the result of step 7 to the result of step 3 (also multiplied by the length of time determined in step 6). This is the optimum level of Working Capital that your business should have.
If this is confusing or difficult to follow, email me (ren.garcia@yahoo.com) or leave a comment / query so I can clarify.
images from Microsoft Clipart
A simple, yet effective formula and extremely similar to the one that I utilize not only for assessing necessary capitol, but also for assessing the profitability of small ventures.
People that provide services rather than tangible goods should particularly take note of their expenses. Even though the expenses are more abstract much of the time (i.e. the cost of “time”) they are expenses nonetheless.
Thanks for visiting, Robert.
Would providing working capital from equity instead of debt be easier to manage?
What do you think? Would love to have a discussion with you on this.
I’m afraid that other than knowing that tracking my “goes-into’s” and “goes-outta’s” as diligently as possible and a few simple calculations to tell me if a venture is profitable, I’m not exactly a financial whiz so I don’t know how much of an inspired discussion I can participate in. :)
But as far as your question, I may over-simplify things to an extreme, but it has ALWAYS worked for me to utilize on-hand assets for leverage whenever possible to offset the need for increased capital. For example, if my company owns warehouse space that I’m not using, then I may rent out a portion to grab some monthly revenue that will keep me from going as deep into debt.
Debt, in my experience, can be a powerful resource for obtaining capital (and IMO is easier to manage) but as a rule, I tend to try to stay away from it whenever possible. Save the credit limit for a rainy day and all that!
Great blog, btw. I just recently found it and I’ve been enjoying the archives.
I’m glad you like the blog. I can see that you’re talking from experience which to me has always been more relevant than book knowledge. I am thinking of writing on when it would be more appropriate to use equity and when to use debt.