As an entrepreneur, making decisions about how much working capital your business needs isn’t easy. Taking on more debt than you can handle will cut into your profits, but not having enough capital may result in stagnation, trapping you in business “Neverland” where you are incapable of growth. So how can you determine the “right-size” capital needed for your business? One place to start is by taking a look at the following factors:
- Your current growth rate
- The industry you are in (and how fast it is growing)
- Where in the business life-cycle you fall
- Existing and available opportunities
Keep in mind that every situation is unique, and there are many factors that determine working capital needs. For instance, if you run a start-up, your capital needs will vary from those of a more established company. What is the one commonality between the leaders of new and seasoned businesses? Those who are planning on taking on more working capital often do so in an effort to expand.
Start Calculating
A good place to start is by completing an analysis of your current operating cycle, which is comprised of inventory, accounts payable and accounts receivable. Just keep in mind that your accounts receivable details needs to be based on the number of days it takes to collect on that account, and accounts payable on the number of days you have to pay the bill.
Another question: Can you finance your operating cycle on your own? If your answer is no, your profits are likely not as high as they should be and you might need more capital to meet demand. Don’t worry – this isn’t always a reflection of your business’ health. There are tons of other factors involved, such as seasonality, the state of the economy or even your current number of employees.
Consider Future and Variable Expenses
While being self-employed definitely has its perks when business is thriving, it can be particularly stressful if you’re faced with financial hardship. How can you prepare for this possibility – the “what-if”? Determining what the worst case scenario looks like – even if it’s unlikely to happen – can help entrepreneurs be prepared for any situation.
When thinking about financial needs, it’s important to remember that capital solutions often differentiate with timelines. How can you determine how the funds you need now might differ from the funds you need down the road? One way is to consider the following questions:
- What do you anticipate your expenses to be over the course of the next year?
- What are your fixed expenses currently and expected over the next year?
- What variable expenses are likely to occur (again, think worst case scenario here)?
- What amount do you need to feel financially safe within your business?
It can often be difficult to peg down a target number without knowing the intricacies of a particular business. But as a general rule of thumb, you should have enough capital on reserve to sustain yourself for three to six months, in the case of an emergency.
Being Realistic Can Be the Key to Accomplishing Your Dreams
One of the most common mistakes for the self-employed is overestimation. While confidence is vital to the success of your business, realistic self-awareness might be even more important.
What does self-awareness entail? Setting conservative, moderate, researched projections and having detailed plans in place for each. If you’re assuming your existing customer base will grow with the expansion of your business, make sure this assumption is realistic, not just optimistic. Are you confident a new product will be a hit with customers? Again, realism should trump optimism. Looking to open a new location? Consider the unknowns. Remember the time it takes to get customers in the door can pretty variable and may not meet the fixed costs you’ve set for yourself.
Determining how much capital your business needs isn’t easy. In addition to the tips above, before you decide the right amount of capital for your business:
· Consult small business resources, like In.Credibly.com for more information on evaluating, sourcing and using working capital.
· Still unsure? Consider using a financial advisor to help identify your strengths, weaknesses and needs.