Understanding Capital Management

Money. Every business needs it. It is required for start up and continues to be required throughout its operation. Without money or the equivalent a business can not get started and any existing business dies.

 

Companies must obtain the needed money primarily by borrowing it or by insuring a debt investment such as a note or a bond. Banks and bondholders expect to be repaid and typically on a fixed date.  Therefore a company’s survival may hinge on meeting such obligations.

 

There are good and bad reasons to borrow. If every borrowed dollar earns a positive return over and above the cost and interest payments than the reason is likely good. If it originates from greed, ego or a desire to breathe life to a poorly planned project than the reason is likely to be a bad one.

 

Financial analysts for corporations distinguish between business risk and financial risk. While business risk is the uncertain income that originates from the companies, cost of production and customer base, financial risk represents the additional uncertainty imposed on the shareholder because the company uses fixed debt securities to pay for its productive assets.

 

Not so long ago, people realized that lending and borrowing were potentially hazardous activities and should be undertaken cautiously and even then only to finance productive investment that provides a means of repayment. This idea is not as popular today with a generation of people being taught to believe that business success results from the use of other people’s money and borrowing is a necessity to make money and stay ahead of inflation.

Although there is some truth to this, the important matter of financial risk is still generally disregarded.

 

If there is any question about this, one can easily recall the recent financial crises and well publicized companies that failed ultimately due to their inability to meet their debt obligations.

 

Even companies that don’t have to borrow long term notes must still exercise tight controls on all income and expenses to achieve long term and lasting success in the market place.

 

Here are few important management formulas for the business owner to consider.

 

Working Capital

 

[i]Liquidity is the ability of a company to pay its debt as they come due. As you might expect, lenders and others are interested in the working capital of a company which is essentially the difference between the current asses and current liabilities.

Current Assets – Current Liabilities = Working Capital

 

Current Ratio

 

The current ratio allows us to compare the liquidity of a company over time. The popular rule of thumb is 2:1 to generate adequate cash flow however many types of businesses have traditionally operated at lower figures. Liquidity is examined monthly or more often if the ratio is low. 

Current Assets / Current Liabilities = Current Ratio.

 

Debt to Assets

 

Also called the Debt Ratio compares what is owed to the value of the assets used by a company. This ratio tells lenders what percentage of a company’s assets are financed or leveraged. As long as some equity exists, the debt ratio is below 100%. If debt is greater than 100% than from a practical standpoint the business is bankrupt.

Debt to Assests = 100 x Total Liabilities / Total  Assets

 

Turnover of  Working Capital

 

This ratio measures the complex relationship between buying and selling. Maintaining a low value insures availability of cash to sustain operations. A ratio that is allowed to grow too high on the other hand could make the company vulnerable if the business climate becomes adverse.

Turnover of Working Capital = Net Sales / Working Capital

 

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[i] Source: 101 Business Rations, McLane Publications, Sheldon Gates, 1993