Carol has taught college Finance, Accounting, Management and Business courses and has a MBA in Finance.
Capital is a critical concept in business management - companies that don't manage their capital well often go out of business quickly. In this lesson, we'll discuss what capital is, how it's calculated, and how a company can determine their upcoming needs.
What Are Capital Requirements?
Capital requirements refer to the amount of money a firm needs to pay for regular expenses and upcoming projects. Let's look at Joe, a small business owner. In his case, the capital requirements are the funds he needs in order to pay salaries to his employees next Friday, the rent and utility payments due on the first of the month, and the first installment for the design of a new advertising campaign.
We can also calculate capital requirements in our home life. You might need funds to pay for your rent or mortgage at the end of the month, cash on hand to cover groceries and incremental expenses, and some extra to set aside toward a vacation next summer.
There are several different ways that the term 'capital' might be used in a business. Let's review some important definitions related to capital.
First up is total capital, which refers to funds invested into the firm by both owners and debtors. For the more accountant-minded, this is total equity plus total debt. These funds are used to generate income for the business, through current operations or allowing for implementation of large projects, such as a new facility or production line. Examples of capital would include money in a bank account, a loan to purchase new production equipment, or cash received from selling ownership in the company.
Our next important term is available capital, which is the amount of cash that the company has on hand at a specific point in time.
We also have working capital, the difference between current assets, including cash and items easily converted to cash, such as CDs, and current liabilities, including current bills you need to pay. It's the cash available to cover regular expenses so you don't have to, say, delay payroll until a customer check comes in.
Lastly, we have long-term capital, which refers to the sources of funds that do not need to be repaid in the next year. In general, it would include funds received from the sale of ownership in the firm, or equity, and long-term debt, like multi-year loans or bonds.
Calculating Capital Requirements
Now that we know more about capital, let's look at how to calculate capital requirements. Generally, the first step in determining capital requirements is to put together a business model or plan. This includes financial calculations that show the expected revenues, expenses, and capital projects. Capital projects are large projects that benefit multiple years, such as system upgrades or adding a plant.
Once the expectations of funds in and out are calculated, the next step is to note the differences. Those differences are the capital that the business needs to raise via investor monies coming in, debt financing, increases in cash inflows, or reductions in cash outflows.
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This is the same process you might use to calculate a home budget: add up your recurring expenses, plus any extras coming up, such as annual payments, maintenance expenses, and funds to set aside for a vacation. The total is your capital requirements. You can then compare this amount to your anticipated income. Any shortfall will need to be addressed through reducing expenses; increasing income, like through adding a second job; or getting a loan.
Why Is Capital Important?
We now know what capital requirements are and how to calculate them, but why are capital requirements important? Well, companies need money available for current operations and to pay salaries, rents, and operating costs. Knowing the capital requirements is essential for this. In addition, funds may be needed for longer-term projects that should improve the company's ability to make more money, such as the addition of a new product line or design of a new advertising campaign. A shortfall can impede the company's ability to make good long-term decisions and may even lead to short-term problems if it has insufficient funds to cover payroll or other current expenses.
The term capital requirement refers to the amount of money a firm needs to pay for regular expenses and upcoming projects. There are different types of capital this may include, such as total capital, which refers to funds invested into the firm by both owners and debtors. There's also available capital, which is the amount of cash that the company has on hand at a specific point in time. And there's also working capital, the difference between current assets and current liabilities. You also have long-term capital, which refers to the sources of funds that do not need to be repaid in the next year. We can calculate capital requirements by first putting together a business model or plan, which includes financial calculations that show the expected revenues, expenses, and capital projects. Then we note the differences to determine the capital that the business needs to raise, which is, of course, the capital requirements.
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