Recently, I’ve been wrestling with this question (why I do this to myself I don’t know). Going through many business assessments and business plans over the past years, it struck me that the normal approach being used is not very scientific. Normally a spreadsheet of some kind is used and the loan amount and monthly payments inserted. The effect of this will then be checked on the cash flow statement and as soon as the cash balance stays positive the amount of the loan is set.
The approach of banks does not really help. Go to the loan calculator of any bank or financing institution and you will be able to calculate the amount of the loan you can apply for. That is the maximum amount they will consider, not the ideal amount for your business. They calculate this by considering different risk factors and what they think your business can afford. A few chats with current and ex bank employees confirmed this. If you apply with the bank and you are considered low risk and have a business that is considered high potential, some banks will offer you the difference of the maximum they will allow and what you applied for as revolving credit.
Look at business sites and you will find that most experts tell you to add together the required start-up capital, the cost of sales for 6 months and the fixed expenses for the same period to get to the amount you should borrow.
My problem is this: If you borrow too little money you might end up with cash flow problems and have trouble getting additional funding because many institutions do not finance operating capital. On the other hand, if you borrow too much money you end up with a lot of free cash that might be spent on non-essentials and rob you of the commitment and urgency that is needed to get a start-up off the ground and profitable. The loan payments and interest on a bigger loan might also end up killing your business.
So what approach is to be used?
I think the approach from business experts of adding Start-up capital, cost of sales and 6 months operating expenses will bring you to the maximum amount of financing you need (assuming your business is expected to break-even within six months). What this equation does not take into account is the fact that (hopefully) your business will in this time also be bringing in money on its own through sales activities, etc.
Furthermore, the minimum amount of finance needed cannot be lower than the required Start-up capital and one month’s operating capital (you need to give your business time to start bringing in the money).
The ideal amount will lie somewhere between these two amounts. The quicker your business is expected to get off the mark and start to generate a turnover, the nearer the ideal amount will be to the minimum level; the slower it is, the nearer the ideal amount will be to the maximum.
I came up with a preliminary formula to take business activity into account to get to the ideal amount of financing. The amounts you will use will depend on when the business is expected to break-even. Let’s assume for now that the business is expected to break-even in the first six months:
Startup Capital needed + Cost of Sales for six months + Fixed Expenses for six months + Debtors’ balance at the end of six months (because you won’t have this money in the bank) – Turnover for the period.
You will subtract the owners’ contribution to get to the basic loan amount and then factor in the cost of the loan (full loan payments and not only interest). Because projections are, most of the time, at least a bit off the mark, you will also have to add a further 20% or so to the loan amount to allow for errors in this regard.
Although the formula is far from perfect and is still a work-in-progress, some preliminary calculations using it on previous actual projections have shown some major differences to the loan amount obtained in this way and the maximum amount mentioned earlier.
A spreadsheet incorporating this formula is available for download elsewhere on this website.
Any thoughts or comments on this are welcome…
Guest Contributor