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What is the Right Amount of Capital For My Business?

Guest post by: Stan Prokop

Article Overview: The article discusses capital requirements for business owners.

What is the Right Amount of Capital For My Business?

Every business, new or existing, is continually attempting to determine what the right mix of ' capital ' is for that particular business. New business owners, unfortunately, are often mis-guided by literature around ' low down payments ', or low owner equity injection. The whole premise around the business dream is quite often pitched as putting the minimum amount down, or into the company, and thereby reaping large rewards on asset and proft appreciation in the firm. The artithmetic is appealing - the less you put in the greater will be your per centage appreciation or return on investment.

Business owners either invest their own funds, or borrow from banks and other related finance firms. New business owners have additional challenges as traditionally the banks have not stepped up to the table to fund the small business environment. They of course prefer external collateral, which in most cases is unavailable, or based around the owners reluctance to pledge personal assets for a business venture.

So the crux of the matter is simple - how much to borrow, how much to put in or invest. Whats the right mix? Commonly this is known as the ' debt' or ' equity ' conundrum.

Bankers and financial personnel have addressed this business owner challenge in a number of ways. One common way is to simply compare the relationship, or ' ratio ' of debt to equity in any firm, either new or existing. If a firm has higher debt levels they are termed highly ' leveraged. Each business owner or corporation eventually determines the right mix of debt or equity. There are always extremes of course. Many large, successful, and well known corporations carry large amounts of debt but are still of course profitable and growing. Interest payments are tax deductible. On the other hand firms with little or no debt simply divide the profits up among the owners of the firm, as debt payments in their case are either non existent or nominal.

What is the right mix of total capital for the business. The answer is simply as follows: there is no right answer. Two companies or business owners can have completely different outlooks and philosophies of how to achieve the final company goals in revenues and profits. Since future results are never known it is incumbent on the business owner or their financial advisor to perform some level of proper analysis arond the right ' operating leverage '., i.e. our main focus in this article: ' What is the right amount of equity and debt for my firm?'

No perfect calculation or debt to equity ratio exists. And lets be realistic, even a firm with no debt can fail if it loses market share or is in a failing industry.

There are however 4 ratios, we have called them ' relationships' calculating optimal leverage regarding debt and equity. They are as follows:

Debt/equity

Debt/total assets

Long term debt/total assets

Current assets/Current liabilities

By using the current actual numbers, and projecting what these ratios might look like in great, good, or bad times will assist any owner or financial manager in determine what the optimal relationship for debt and equity is in their firm.

In summary, any new, existing, or even public firm must continually weight the right amount of debt and equity in the company. More equity means less profits to be shared by more owners; more debt means that future alternatives have limitations and the firm can make less mistakes given its debt load. Careful analysis of the right mix of equity and debt capital is a must for all companies of any size.

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Article Tags: capital, debt, debt vsequity



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