Capital: Its Uses & Sufficiency
December 22, 2009, 8:37 pm
Copyright © 2009 Integrated Profitability TM
A previous article, “Capital: Its Purposes & Sources” covered:
|
Purpose |
Uses |
| Initial seed money for new ventures | Purchasing assets, paying for operations & processes, acquiring customers |
| Ongoing buffer for adverse impacts | Covering losses in the ongoing business |
Initial infusion of Capital: used for setting up the company, acquiring office or factory space, hiring personnel, obtaining contracts and service agreements with companies who will provide manufacturing, services or risk protection (e.g., insurance), buying equipment, furniture and other assets.
Ongoing buffer for business: used for adverse market, business or self-inflicted problems that are large enough to cause a loss, i.e., net-profit becomes negative. There is an unending list of such adverse impacts. Here are a few market-based ones:
● You lose your largest customer and can’t reduce expenses fast enough to offset the loss of revenue
● A competitor brings a materially better product to market and buries you
● Your manufacturing process produces a major flaw and you are required to do a massive recall
● Your key supplier goes bankrupt and it costs significantly more to replace the goods
● The national and world economies fall into recession and demand for your product or service dries up
The Antioch Unified School District is in the midst of adverse conditions right now.
When any of these events cause your net-profit to go negative, the amount of retained earnings accumulated during earlier, more profitable years are used to cover the losses.
Given these purposes and uses, how much capital is sufficient for any given company? Calculating this amount depends on the profit dynamics of each business and the market it is in. Some businesses have fairly steady profit profiles (e.g., grocery stores), while others have wildly erratic ones (e.g., investment banking).
Irrespective of the business’ profitability profile, the first step is understanding, estimating and quantifying the types of risk facing your company. With these scenarios and estimates in hand, the following questions need to be asked:
1. what is the largest loss possible if all the risks converged at the same time on the company?
2. how long would the risks adversely impact the business of the company?
Based on intimate experience with your company’s business and its market, probabilities may be applied to different scenarios involving the various risks.
The amount of capital needed for a particular business should be the amount needed to stay in business for at least one year; two years is a much more prudent goal. With this amount of capital available, the company will have two years to deal with whatever business challenges it is facing.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 47
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
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