Capital: How Much is Enough… or Too Much?

“How much capital should I have in my business?”

That’s a question I hear quite frequently from business owners. While this may seem like a simple question, the answer is rarely simple at all. The level of capital you need depends on the type of business you have and how quickly you can convert your inventory or services into cash. For example, a grocery store generates cash every day the doors are open, whereas a law firm may not get paid for 60 days or longer after delivering a service. Thus, the capital requirements for each of these businesses will be considerably different.

You can, however, figure out a number that works best for your business by analyzing your working capital ratio and doing a little bit of math. The working capital ratio (current assets/current liabilities) measures operating liquidity and a business’s ability to meet short-term (upcoming) obligations. Current assets are cash or assets that are expected to convert into cash (e.g. receivables and inventory) within a one-year period or within the normal business operating cycle. Current liabilities are the counterbalance due within the same time period. A ratio of less than 1 indicates negative working capital (more liabilities than assets), while a value of 2 could indicate excess assets, which also can be an issue.

One practical method to determine the right amount of working capital is to run your business through a simulated stress test. If business dropped by 25% and collections slowed, could you make it for 6 months or more with your current capital and financing? Consider the fact that many businesses that stumbled in late 2008 are just now stabilized and back on their feet.

If you determine that your business’s capital is too low, talk with your accountant and attorney. One strategy is to raise capital over time by leaving some extra in each year until the desired level is achieved.
When a downturn comes along, having capital in the business becomes vitally important. Asking shareholders or members to put money in the company is a difficult conversation and, in a lot of cases, they simply don’t have it. If the company has retained adequate capital, you don’t have to ask—you already have their money. While financials and numbers are great tools to manage a business, they are not the only consideration when it comes to cash and working capital.

Many businesses utilize a line of credit. The line is used to fund short-term gaps like receivables, inventory or work-in-process. Leverage is great as long as business is steady. When it comes to lines of credit, bigger is better—just be smart about using it. Often, businesses make the mistake of financing long-term assets using a line. If you’re buying vehicles or equipment, ask your banker about a term loan.
Also, there’s this: Most shareholders never consider the potential personal liability on a bank line of credit. Bank lines generally provide for joint and several liability meaning the bank can come to all parties (owners) for the full amount owed. So in a three-owner business, the bank could collect the full amount from any one shareholder leaving him or her to collect from the others. As one banker told me, “When banks have to collect, they take the path of least resistance.” Less borrowing and more equity means less risk for shareholders—especially those owners who are financially stronger than others. If this is a concern, next renewal ask your banker if a reduced proportional guarantee is an option.
Having too much capital is also a reason to evaluate alternatives.

Some businesses simply have too much cash on hand. Unfortunately, in these cases business lawsuits are a frequent occurrence. In any case, the situation needs attention. We were finally able to convince one client who had accumulated excess cash to distribute funds to himself. If the business needs it, we told him, he could lend funds back. The same situation with a multi-owner business might call for a different solution.

Again, the answer to the question of how much capital is enough is unique to your own business and situation. You can, however, determine the optimal balance within your company and, with the above advice and cautions as a guide, take steps right now to put in place a system that works best for you.