Early stage businesses, especially small to medium-sized enterprises, quickly learn the importance of having sufficient working capital to support growth, writes Investment Manager Bill Girard. Why then do so many fall short of doing sufficient analysis to determine their working capital needs?

Their analysis is often limited to simply adding up the cost of a few months of variable costs along with several months of overhead costs such as rent, insurance, utilities and concluding that this total is how much working capital they need. My experience is that most entrepreneurs underestimate their working capital needs. This leaves them exposed to unanticipated, but in fact avoidable, shortages in cash in the future.

Working capital needs are based upon a number of factors. These include but may not be limited to such things as:

  • the production cycle of your business–how long it takes you to turn inputs into marketable products;
  • how fast your inventory “turns over” or is converted into sales;
  • the payment terms you provide your customers and the credit terms you have with your suppliers.

An effective method for determining working capital needs is to prepare a cash budget. This is essentially a spreadsheet, normally prepared for a 12-month period, laying out in detail the projected monthly inflow and outflow of cash for the business.

It's important to remember that a cash budget focuses on the monthly flow of cash, not just monthly sales and expenses. Effectively projecting sales and expenses is great. But when will you collect the cash from these sales and when will you need to use your cash to pay for expenses? These are critical questions.

Many businesses that are profitable can run into problems because they have insufficient working capital with which to operate and grow. When done properly, a cash budget allows business owners to see if and when they will have monthly shortages of cash.

Knowing this in advance of speaking to your business lender makes you better prepared to discuss your lending needs. And lenders like loan applicants who come well prepared to seek financing. But more importantly you will be better prepared to manage your cash resources and your growth.

With many of my clients, I have found a cash budget to be one of the most useful tools they can have for the successful operation of their business. This is why I often take the time in the loan application process to assist business owners in preparing a proper cash budget.