Puzzled about how much your firm should borrow? Try these guidelines to come up with a figure.
You know your company needs capital-money for raw materials, promotions, inventory, and payroll-but you’re not certain just how much cash you’ll need over the coming months and years. No matter how you twist the puzzle pieces, the answer escapes you.
You’re not alone. When it comes to borrowing money or arranging credit lines, CEOs know they need enough to grow the business and see it through sluggish periods. The question is, How much is enough? How do you account for ongoing needs, for seasonal requirements, for the unexpected?
You do it by studying your company’s business cycles. This reveals when and why you need cash and that becomes the basis for your borrowing strategies. Most important, you calculate the flow of cash out of the business for inventory and the other costs, and then compare this to the time it takes to recover that money through the collection of receivables. What you’re looking for is sufficient working capital to close the gap between disbursements and collections.
If you have traditionally based your cash projections on gut instinct and seat-of-the-pants estimates, chances are that you have come up short when your company could least afford it. To prevent this crisis-to-crisis method of financial management try bringing some science to the critical task of projecting your company’s capital requirements. The approach outlined here uses information from your company’s financial statements:
* Determine your collection period. For simplicity’s sake, assume that your annual sales are Rs. 3,65,00,000. Dividing this figure by the number of days in the year gives average daily sales of Rs.1,00,000. If your accounts receivable balance is 60,00,000, you have a collection period of 60 days.
* Perform a similar calculation for inventory. Suppose your cost of goods sold is Rs.2,20,00,000. Dividing this by 365 gives daily costs of about Rs.60,000. If your inventory is Rs.27,00,000, then you have 45 days of inventory on hand.