Determining Your Business' Capital Needs

Let's start with two definitions.

"Capital," in investing terms, is money used to finance purchases of equipment, supplies, or products. If you want to buy a new piece of equipment, the money you will spend to purchase that equipment is considered Capital.

"Working Capital" is the money you need to spend to cover the day-to-day operating costs of your business. Working Capital is cash − or accounts that can be converted into cash, like accounts receivable or inventory − and cash you need to spend to cover financial obligations falling due in the current operating year. To keep it simple, think of working Capital as the money you need to pay the bills.

So: To determine your Capital needs, you'll need to consider both Capital and working Capital; the total is the amount you'll need to operate your business.

Let's start with Capital you'll need to make major purchases. Potential sources of Capital outlay include:

• Buildings, facilities, etc.
• Major equipment.
• Office equipment and furnishings.
• Materials, supplies, parts, etc.
• Initial inventory.

If you are planning the Capital needs of a start-up, simply write down the costs of setting up the business. If you run an existing business and need Capital to expand, write down the costs of that expansion. (But don't include items like salaries, utility costs, insurance, etc − we'll get to those items in a moment.)

Then focus on your working Capital needs. To make it simple, we'll assume you run an existing business and are looking to expand. In that case, to determine working Capital requirements create projections for items like accounts receivable, inventories, and accounts payable. Then compare your current actual costs to the figures you forecast. Then subtract the increase in current liabilities from the increase in current assets. The difference is your change in working Capital and indicates how much money you'll need.

If you are seeking Capital for a start-up, it's even easier: You don't have current actual costs, so the difference in liabilities and assets equals your working Capital needs.

Here is an example. Say you plan to open a new restaurant. (We'll keep the math simple.) You estimate the following Capital costs:

• Facility (building and land)	$500,000
• Equipment (stoves, freezers, etc)	$150,000
• Furnishings (tables, chairs, etc)	$75,000
• Other items (silverware, plates, etc)	$20,000
• Etc.
Total	$745,000

You determine you require $745,000 in order to open the restaurant. But that is not all the Capital you will need; you'll also require working Capital to keep the operation going while the restaurant gets on its feet. You estimate the following in working Capital needs for the first twelve months you are in business:

• Salaries	$400,000
• Utilities	$25,000
• "Groceries" (supplies)	$50,000
• Advertising	$15,000
• Etc.
Total	$490,000

Adding Capital and working Capital together indicates you'll need $1,235,000 to cover the first year's expenses. (You'll probably need more, since neither list above is in any way complete.)

On the other hand, you will bring in cash as customers patronize your restaurant. You run a variety of different scenarios and decide you feel comfortable assuming you will do $800,000 in sales over the course of the first year.

The math is simple: $1,235,000 minus $800,000 equals $435,000. You need $435,000 in Capital to open the restaurant.

But take a step back first. While you have estimated you will do $800,000 in sales, those sales are unlikely to be spread evenly across twelve months; your first few months are likely to be lean as customers learn about your restaurant and your sales build over subsequent months. Plus you need at least $745,000 to cover the costs of getting the restaurant started.

In addition, to cover potential shortfalls, you decide you need an additional $200,000 as a buffer for lean months and in case unforeseen expenses arise.

Taking into account your initial needs, and a buffer, you determine you'll need a total of $1,435,000 for the first year, but since you expect sales to rapidly increase as customers flock to your restaurant, you cut that total amount by $300,000 because you can use income to offset some of your working Capital needs.

Then, to present a great case to investors and lenders, you lay out those Capital needs on a month-by-month basis, showing working Capital requirements and offsets due to accounts receivable. In short, you show lenders and investors what you need, justify those needs based on solid forecasts and estimates, and show how you will pay back the money you borrow. The key is to factor in Capital needs and working Capital needs; don't let your business fail because you didn't estimate and plan for working Capital required to cover operating expenses