Calculating Capital Into Your Business Value
It takes money to make money, and perhaps the biggest evidence for that fact lies firmly in the concept of business capital.
Before your business began operating, you likely had to make some pretty sizeable investments in equipment, property, and advertising. You did so in the hope that creating enough capital would help you sell your product or service, eventually giving your a return on your investment.
During a business sale, your buyer is going to look closely at your working capital, which focuses on short-term liquidity. This form of capital is represented by the difference of assets to liabilities, and if your business is able to pay those liabilities with some assets left over for reinvestment.
Assets and Liabilities
Investopedia sums up the difference between assets and liabilities nicely:
“[Assets are] what a company currently owns… that it can easily turn into cash within one year or one business cycle… [This includes] checking and savings accounts; highly liquid marketable securities such as stocks, bonds, mutual funds and ETFs…
In similar fashion, current liabilities include all the debts and expenses the firm expects to pay within a year or one business cycle..This typically includes all the normal costs of running the business such as rent, utilities, materials and supplies; interest or principal payments on debt; accounts payable; accrued liabilities; and accrued income taxes.”
As you near your transition, you have to step back and inventory all the capital that is still available to your business. Sales transactions that represent a healthy asset-to-liability ratio are going to give you a much larger ROI than ones that show too many liabilities and too few assets.
Calculating Your Capital
Calculating capital in your business value equation provides your buyer with a more comprehensive picture of what they are investing in, giving them peace of mind that this purchase will continue to make them money well into the future.
When calculating the ratio of assets to liabilities, you’re looking for an answer greater than 1. The higher the number, the more indicative it is that your business can liquidate quickly and settle liabilities.
Let’s look at an example:
Tamara Quinton owns a small accounting firm that has the following debts and assets:
- Cash on Hand: $19,000
- Inventory and Equipment: $8,000
- Accounts Receivable: $5,000
- Payroll: $8,500
- Other Debt: $9,000
- Rent and Utilities: $2,300
Using a very simple equation, Tamara could calculate the amount of working capital that she has available:
Current Capital = Current Assets/Current Liabilities
In this case, Tamara’s total current assets equal $32,000 and her current liabilities total $19,800.
$32,000 ÷ $19,800 = 1.61
This ratio tells us that Tamara currently has more than one dollar of assets for every dollar of liability, or $12,200 worth of funds to reinvestment, repair, or expand her business assets, while still able to pay off all liabilities owed. A seller who is looking for a “sure bet” business would be thrilled to see such a high ratio of assets to liabilities, as it indicates that even during the transition following the sale of the business, it is still able to make enough money to deal with short-term financial obligations.
In the Green: Preventing Negative Working Capital
When your business has enough assets to cover all current liabilities, you are said to have “positive working capital.” When the reverse of that happens, and you cannot cover your short-term liabilities, you are dealing with “negative working capital.”
To a buyer, negative working capital is a risky investment. It tells them that your business isn’t making enough money to be a worthwhile return on their sale, and it indicates that growth into new markets won’t happen anytime soon. As you get closer and closer to your transition, it is imperative that you avoid negative working capital. In fact, the farther back that your history of positive working capital goes, the more valuable your business will look to your buyers.
If you need help getting over the negative working capital hump, there are some short term solutions that can put you on the right track.
It is worth noting that these solutions are best for businesses who are dealing with predictable seasonality, temporary financial setbacks, or investing in something that can’t be passed up. Adding more liability to your equation without knowing whether or not your assets will increase is not wise.
If you can find an investor, either third-party, friends, family, or your own resources, you can give yourself a bump in assets that can be paid back once you’re in the green again. This is especially common when a new business hasn’t become profitable yet, but it’s not unheard of for an established business to look for additional equity.
Line of Credit
If your business has a history of good equity and bears worthwhile collateral, banks will consider giving you lines of credit to fund expansions, investments, or remodels. Typically, these lines of credit are short-term and paid back over a set amount of time according to the estimated accounts payable you recieve.
Short Term Loans
If your business doesn’t qualify for a line of credit, you may still be eligible for a short-term loan. These loans are paid back over the next year and can give you a quick infusion of cash to help fund short-term projects. For example, you can repair broken equipment, restock your inventory, or deal with an unusually large payroll cycle.
Want to avoid taking on more debt? The best way to create a healthy capital ratio is to combine this metric with other measures of business value, like your impact on quality of life and the social capital that you hold in your community.
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