How much capital do I need to run my business?

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided. 

How much capital do I need to run my business? How do I know whether I am undercapitalized? Why are we chronically low on cash–even though the business is showing profit?

If these questions sound familiar to you, you’re not alone. Many of our auto-industry clients (and many clients in other industries, too) find themselves agonizing over these issues at one time or another. Part of my job as their C.P.A. is to answer the questions and show them how to avoid the “capitalization blues.”

What We’re Talking About

For most people, the problem begins with language. “Capital,” “working capital,” and “retained earnings” all sound more or less like the same thing. Yet they’re not.

Capital is a company’s total assets minus its total liabilities. It can be created in two ways: through retained earnings–accumulated earnings left in the company to be reinvested in plant, equipment, or working capital–or through cash or other assets invested by owners.

Working capital is a company’s cash, and other assets that are readily convertible to cash, minus any debts it expects to pay in the year to come. The amount of working capital you have is a measure of your liquidity; it tells you whether you’re able to pay your debts as they come due.

How Much Is Enough

The amount of capital necessary to run a business varies by industry. In general, though, it’s a function of how much you need for plant and facilities; your cash flow; your ability to acquire financing; and your growth plans.

For auto dealerships, proper capitalization usually equals an amount that will provide for operating equipment, parts inventory, used car inventory, one to one and a half months of non-vehicle sales, and one to two months of operating expenses. Ideally it also provides a reserve to get you through rough times. In other words, it’s the oil that makes your business’ engine run smoothly and efficiently

This rule of thumb gives us a clue about why a “profitable” company may run into capital trouble. The income statement shows profit, but the company’s assets are tied up in inventory and receivables. Bills are going unpaid, and the payroll can’t be met.

Are You Undercapitalized?

Here are some warning signs that indicate your dealership may be undercapitalized:

• Your bank account is continually overdrawn.
• You have to floor used vehicles to generate cash.
• You’re incurring payroll and sales tax deposit penalties because of late payments.
• The only way you can replace machinery and equipment is by leasing.
• You’re special-ordering more and more parts because your stock levels are so low.
• You can’t qualify for a working-capital line of credit.
• You’re stretching your trade payables beyond the normal payment terms and an increasing number of vendors demand C.O.D.
• Your used-vehicle inventory is too low to service the market.

These warning signs may or may not indicate a capital deficiency. However, if you nodded “yes” to more than one of them, it may be time for a financial tune-up with your C.P.A.

The Diagnostic

To identify your dealership’s problem areas, try taking this brief quiz:

1. How much time do you spend at your dealership? Absentee management simply does not work. At most well-run dealerships, the owner is on the premises most of the time and makes his presence felt.
2. How timely and accurate are your financial reports? Do you have significant 13-month adjustments? A good financial reporting system can actually save you money and is critical to success.
3. Are you experiencing management turnover? The ability to hire and retain well-qualified people is directly related to your bottom line.
4. Has your CSI changed recently? If so, why? How do your employees feel about customer service?
5. Does your internal-control system safeguard your assets and assure proper recording of transactions?

The Major Service

Now that you’ve looked under your hood, it’s time to fix what’s broken. Here are the most common areas of concern and what you can do about them:

• Figure out your monthly “nut. “This is the number of new units you need to sell to break even. If you don’t know what it is, you can’t manage effectively from month to month.
• Pinpoint your bottlenecks. Once a new vehicle is sold, it should take no more than seven days to convert the finance contract to cash. If this isn’t happening, figure out why-and resolve the problem.
• Manage your inventory. Effective vehicle inventory management can make or break your dealership. You need an inventory reporting system that will age your inventory of new and used vehicles. You need to continually evaluate your salesman “compensation” plan to provide incentives to sell slow moving units.
• Clean up factory warranty receivables. If you have significant amounts over 90 days past due, you may have one of two problems: improperly processed warranty claims or poor follow-through on partial payments.
• Be up front about rebates. Poor communication between the finance department and the accounting department has resulted in the forfeiture of more than one rebate.

An honest appraisal of these potential problem areas can help you recognize your capitalization needs and strengths-and give your business a jump-start toward a healthy financial future.

This article was written in 1994.