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How Much Money Do I need to Operate?

Posted on April 28th, 2019

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Your young start-up business is now taking off.  Sales for the current fiscal year are expected to increase from $110,000 to $500,000. Until now, you’ve been able to operate out of your home, purchase inventory as needed, and sell it immediately to customers who have either prepaid, or pay cash on delivery (C.O.D.).  So what does this new growth spurt imply in terms of the funds required to operate your business?

Assume your business is a wholesale distributor of some kind, and the following changes in the way you currently operate will occur:

  • You now need to stock at least a 30 day supply of inventory, and your suppliers offer 30 day payment terms.
  • In order to stock inventory, you need to lease warehouse space, hire warehouse staff, and purchase a delivery truck.
  • New customers will insist on 30 day payment terms.

Now further assume that, for whatever reason, you overstocked on inventory so that you are running at a 60-day supply of inventory on hand; and, the reality is that your customers are paying you on average in 45 days.  This is what your projected Profit & Loss and Cash Flow now looks like:

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Note in particular the amounts highlighted in yellow.  Even though your business is projected to be profitable at the higher level of sales (see Income Statement), your cash balance declines by $34,000 (rounded), plus you are required to either borrow another $11,000 from a bank or other outside source, or personally invest from your own funds, for a total of $45,000 (see Balance Sheet and Cash Flow Statement).  And what if you had not anticipated this funding requirement, what would you do?

The financial concept I am alluding to is called “Permanent Working Capital,”  defined in this article (click on link) as “the minimum level of current assets required by a firm to carry-on its business operations.”  In other words, it represents a “permanent” funding need.  In contrast, a “seasonal” working capital requirement, wherein increases in inventory and accounts receivable, and the funds required to support these increases, would be of a temporary or “short-term” nature.

The distinction between “short-term” and “permanent” working capital is critical for planning your company’s cash requirements. The difference it makes determines not only how much money your company needs to operate, but also when and where it must come from.  Banks typically do not lend money for permanent working capital unless they have some tangible collateral to secure the loan with, such as your house.  So that leaves: commercial finance companies that lend on receivables and inventory at a much higher rate of interest; an SBA (Small Business Administration) loan; a private investor such as your rich relative; or, your own personal savings account.

For more information, see also below articles.

Related Articles:

The Effect of Sales Growth on Cash Flow

The Relationship Between Turnover Ratios and Cash Flow

Strategic Financial Planning vs. Crisis Management 

Securing a Small Business Loan Revisited



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