Running a small business: Two sorts of capital, one big headache

Part five of WADE GLASS and GARETH HOOLE'S 10-part series on how to start a business.


In our previous article we spoke about the importance of business planning and here we examine, in more detail, the amount of capital you will need to make your business succeed.

We previously said that few businesses fail in their first year unless they are grossly undercapitalised. As a general rule, whatever your initial estimate is of your capital requirement for the business, it will probably not be enough.

When you have determined the break-even point of your business, that point where your revenue equals your costs, you will know the scale of operation you require and you then need to determine what assets are required to sustain that level of business.

As a practical example, if a courier business needs to make 20 deliveries a day to break even and each delivery requires half an hour, they know that they need to achieve 10 active hours. Assuming a driver will work an eight-hour day, it is clear that in a standard day one driver will not be sufficient.

Therefore, the human resource need is for at least two drivers and that means two vehicles and enough support to sustain two active "income earning units".

Now you have to perform a costing exercise to determine how much fixed capital you will need. What is cost of the fixed assets the business requires? How much inventory do you need to ensure that you will be able to satisfy demand and keep something in reserve, without over-stocking the warehouse?

At this time we should examine the difference between fixed and working capital.

Simply stated, fixed capital is what you need to buy the hard assets of the business, generally the long-term assets such as plant, equipment, furnishings and vehicles. Working capital covers the short-term requirements such as inventory and debtors.

It is the assets of a business that generate the income and the more efficiently you structure those productive assets the more likely you are to maximise your income.

Very few entrepreneurs starting out in business have enough resources to acquire the necessary assets for cash and thus need to borrow.

Our next article examines funding alternatives in more detail, but it is important to obtain the most effective form of funding to meet your capital requirements, the reason being that borrowed capital has a direct cost.

A simple example of this is a bank loan. You borrow money from the bank to use in your business to buy equipment. In return the bank charges you interest. The interest is a payment to the bank to compensate them for the fact that you are using their money and therefore they cannot use it to invest in other ventures, together with the risk they face from your defaulting on the loan.

Simply, when you have borrowed money to buy an asset you will need to be sure that it will generate more than enough income to repay the bank its capital and interest over the life of the loan.

So this means that you will have to undertake some capital budgeting to determine how much money your business is going to require for it to survive.

There are numerous tricks and traps in preparing a good capital budget and many concepts with which you may not be familiar, such as taking account of the time value of money.

For this reason you should seek professional advice.

Fixed assets are not the only capital requirement. As stated, any business needs working capital too. We have previously addressed the importance of careful cash management and unfortunately few business will generate large amounts of cash from day one.

Generally, businesses go through a conversion cycle, a delay between spending money and earning it and this represents the need for working capital.

Again, this is best illustrated by a simple example. A small furniture manufacturing business commences operations. The proprietor determines a need for an office assistant and two factory workers. The business needs to buy raw materials and also needs a vehicle, tools and equipment and office furniture.

They need space from which to work and a telephone service as well as other utilities. Office supplies and consumables need to be bought and the staff must be paid, probably weekly.

From the very outset, there is a funding requirement and it is likely that the proprietor has a limited supply of ready cash.

In the first month of operation, they manufacture furniture and then sell it to a customer under normal trade terms of 30 days which means that they are not going to see any cash inflow until the third month of operation.

All the while there are outgoings which need to be met. This creates a shortage of cash in the early life of the business which must be funded with capital provided by the owner.

If the proprietor of this small business had used up all his available capital to set up the business, acquire the operating assets and raw materials, he would now be facing a cash crisis.

This is overcome by determining the fixed and working capital requirements upfront and striking an acceptable balance of owner inputs and borrowed funds, making sure that the owner has capital available to meet his obligations as they fall due.

We recently consulted an importer of consumer goods. There was a strong market for the goods but the problem facing the business was that the supplier required payment before the goods were shipped.

Several weeks passed before the goods arrived and then, even though they were sold immediately, a period of 30 days lapsed before payment was received. This created a 60-day cash flow deficit that became more severe as the business grew. We had to plan cash flows very carefully and arrange revolving credit facilities to assist.

We again return to the importance of planning and budgeting. You must determine exactly how much you will need, making allowances for unexpected contingencies. Perform a sensitivity analysis, trying a series of "what-ifs".

Budgeting the fixed and working capital needs of a new business is tricky and crucial to the success of the venture. Be conservative, plan for the unexpected and always keep something in reserve. If you are uncertain, seek professional advice, it could be the best money you will ever spend.

The series continues on Monday with a look at how you can borrow to meet identified capital requirements.

* Wade Glass (assistant manager) and Gareth Hoole (associate director) are chartered accountants in the Corporate Recovery Services unit of Staples Rodway, Auckland. The views expressed are their own and not necessarily those of Staples Rodway.

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