Cash flow is the lifeblood of any small business. In order to maintain stable and consistent business, owners must have access to capital. Usually small business owners can expect that normal operations will provide enough funds that the firm will not have to raise capital. However, it is likely that in the long term a business owner will have to raise capital by attracting investors or by borrowing. One way for an owner to limit the need to raise capital is by always maintaining an appropriate amount of working capital. Working capital is the amount of cash and other short-term assets in excess of short-term obligations. It is a buffer of capital that allows companies to fund any unforeseen financial risks. Since working capital reserves ensures that a small business will be able to continue operations, maintaining adequate working capital reserves is one of the most important means to mitigate business risk.
Even in the best economic times, small business owners may have a need to raise capital. For example, normal cash flows from business operations are not usually enough to finance the purchase of the fixed assets needed to support business expansion. Whatever the reason, a growing company can often find alternative ways to raise investable capital.
Raising capital from shareholders, lenders, or even trade credit from vendors requires superior business credit and credibility. One method to support credit and credibility is to always have enough working capital reserves to fund current liabilities. The ability to pay debts on time and without incident is the key element in building both credit and credibility.
Effective owners and managers are the ones that have learned to maximize their invested capital and to minimize working capital reserves without taking undue business risk. It is not wise to over invest in the business if it means reducing working capital to the point that it no longer serves as means to mitigate risk. On the other hand, it is equally unwise to reduce the amount of investable capital by maximizing working capital far beyond what is needed to finance any potential financial issues. In order to determine the correct balance between investable and working capital, owners needs to conduct a significant amount of cash flow forecasting and scenario analysis to determine the minimum amount of working capital necessary. The first step in the analysis is to forecast the amount of cash inflows from operating the business. The next is to determine the multitude of potential financial scenarios and risks that could take place and to highlight liabilities that would occur and the requisite cash that would be needed to fund them. Once the minimum working capital requirement is calculated, owners can manage both receivable and payable turnover to ensure that the appropriate working capital is available at all times.
For the inexperienced owner, raising capital can be problematic. There are several ways that firms attempt to raise funds and increase working capital. Some attempt to increase sales, others age their accounts payable, while others obtain lines of credit to supplement cash reserves. One method to acquire additional capital is to sell assets. Although it may seem contradictory to convert assets to cash, especially if assets are sold at below their book values, selling assets can be the least expensive way to raise capital. In fact, the fees and other costs involved in raising both equity and debt capital can make each of them rather expensive. When selling assets, the sales price can sometimes be less important than the potential investment return that can be achieved with the additional cash. There are often opportunities to sell unproductive or marginally productive assets and use the cash to invest in assets that can support increased revenues and business expansion. It is often more efficient to sell assets than to use personal (credit cards etc.) or business credit to raise the necessary capital.
Internally generated capital, whether it is derived from operating the business or selling assets, is the cheapest source of capital. Since it is less expensive, it also produces much higher investment returns when the capital is employed. The following highlights one way to increase working capital and investable funds without having to attract funds from external sources:
Maintaining an appropriate amount of cash reserves and finding money to support expansion can force small business owners to be creative when raising capital. Instinctively, most owners think of borrowing money or finding partners to obtain the necessary funding. However, there are usually other means available to acquire the necessary capital. By analyzing the drivers of revenue and determining working capital needs, owners can find cheaper ways to fund financial obligations without using other people’s money. Using these alternative methods to raise capital will help support a firm’s business credit and credibility, which will ultimately help owners raise external capital, if doing so becomes a necessity.