Managing Capital vs. Cash in Your Small Business

The differences between cash and capital management for small business owners

09/18/2014

Small business owners know how important it is to manage their cash flow, but they may be unsure exactly what this entails. Another common source of confusion among small business owners arises regarding the difference between cash and capital investments and figuring out how to manage both. The following information will help you determine how to best manage your small business’s capital and cash.
 

Managing capital investments

 
Capital, also known as a capital investment, refers to a long-term, fixed asset. It’s important to identify and evaluate all of the capital investments that your business might become involved in, so that it’s possible to budget and manage them.
 
The first step in doing this is to determine the value of your capital investments. Once you understand the value of your current investments, you can subtract the total current liabilities to determine your business’s current working capital.
 
“The financial process for determining the value of capital investment projects, such as buying a building or a piece of equipment and determining the value of stocks and bonds is exactly the same. They are all assets in which a firm invests,” states About.com Business Finance writer Rosemary Peavler, Professor Emeritus of Finance at Morehead State University.
 
Businesses have more diverse opportunities for investing in capital projects than for investing in financial assets like bonds. This is because a business creates a capital project, by purchasing a building for example. On the other hand, there are a fixed number of financial assets like stocks to choose from.
 
There are two types of capital investment projects, and learning the difference between the two is critical for budgeting and managing them. The two types are mutually exclusive projects and independent projects.
 
Mutually exclusive projects are those that are similar enough to other projects that become tied together in such a way that the operation of one impacts the cash flow of the other. Independent projects, on the other hand, don’t have an effect on the cash flow of other projects.
 
“The most important thing that a business owner absolutely must do is compare the rate of return that the project will earn to the weighted average cost of capital or what the company pays to obtain financing,” states Peavler.
 
Once you make this calculation, you can reject the project if the rate of return is lower than the weighted average cost of capital. Likewise, you can feel confident accepting the investment if the rate of return is higher. This is a complex equation, so it is best to talk to your local financial institution or financial advisor when making decisions about capital investments.
 

Managing cash flow

 
Cash flow is the cash that your business generates during a specific time period. Because you likely sell services or products on credit and borrow loans, cash flow is more complicated than simply matching your business’s net profit. In order to understand your business’s cash flow, it is necessary to examine the Statement of Cash Flows prepared by your accountant.
 
The Statement of Cash Flows will illustrate that variation during different time periods, which is why understanding both your cash flow and your working capital is important for understanding the big picture of your business’s finances.
 
“Monthly or quarterly cash flows will naturally be very different from the amount of cash generated over a 12-month period,” states Hunkar Ozyasar for the Houston Chronicle. “As a result, working capital provides an excellent idea about how easily the company can pay immediate liabilities, while cash flow is more of a forward-looking measure.”
 
One of the best ways to manage your cash flow is to budget cash six months to a year in advance. This budget is important for determining the difference between your business’s profits as reported on the income statement and its cash flow.
 
In order to maximize your cash flow, take a close look at inventory and accounts receivable. This can help you determine if you’re carrying obsolete inventory or selling out too quickly. It can also help you determine how quickly credit customers are paying accounts. Adjustments to both of these categories can be one of the most certain ways to maximize your cash flow.
 
“Starting with inventory and accounts receivable, if managers can maximize their cash flow, they can almost always avoid running out of operating cash and exposing themselves to cash flow problems,” states Peavler.
 
If you would like to discuss the cash flow, working capital or capital investments of your small business, please don’t hesitate to give us a call.

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