Finance From A-Z: Capital Budgeting

Term: Capital Budgeting

Definition:
The process of determining the amount of money to set aside for the purchase of fixed assets and long-term projects – this includes determining which are worthwhile by comparing the investments choices using some type of project evaluation method like discounted cash flows, Return On Investment (ROI), payback period and  internal rates of return (IRR).

What Does This Mean To Me:
Often capital budgeting is thought to be a large business activity vs. a small business one. That is because large businesses can have multiple projects that need to be evaluated and determined which are the best investments. However, it is just as important, if not more important, for small businesses to plan how each excess dollar is spent.

The small business challenge is identifying enough viable projects to choose from so extensive analysis is justifiable.  Contrary to what some business consultants recommend, I encourage small business owners to do more analysis – not less. My logic is that the smaller you are the less margin for error you have and there is less profit to cover up your mistakes.

Capital Budgeting Process:

Here is one exercise I use for capital budgeting. I work with an owner or management team and lead them through a six step process.

  1. First, we prepare a Cash Flow Budget for the up coming year. It includes forecasting revenue and operating expenses. This  includes interest and principle payments on loans.
  2. Next, we determine if there are any cash flow short falls. If so, identify the recovery source.
  3. Now, w e identify potential Fixed Asset purchases or Projects that cost  greater than $500. These are items or projects that will help grow the business in some way and have been deemed “strategic”. These projects are ordered by spending amounts and then weighted by qualitative factors like: impact on business objectives or customer relation impact. The weighting is usually on a scale of 1 – 5.
  4. Then we look at the top 20% of the items or up to 80% of projected excess funds and these are the projects we evaluate.
  5. Next, we conduct the evaluation. The evaluation methods vary. It could be discounted cash flows, ROI or IRR. However, I always encourage that some type of time value of money methodology is used.
  6. Finally, We then select our capital spending items. Depending on actual available cash and the current business environment, we execute on the capital budget.

This process assumes that there is a financial performance review process in place and the company has documented goals – but that’s a whole other discussion.

Click on this link for a cash flow budget spreadsheet to get you started. But remember the tool is only as good as the plan to use it and the quality of the execution.

Manch Kersee
JR Dexter, Inc. – “Business Decision Support”

When Should a Business Hire Additional Staff?

After reaching a measurable level of success, a business owner must consider if they should hire additional staff.  The average salary for a small business employee is $30,000 to $35,000, annually. Source: http://www.ehow.com/i/#article_6659754 This equals weekly revenue of $693 – $808 (fully loaded with taxes and benefits).

When can a business afford to hire additional staff?Now Hiring Button

This seems like a simple question but it has various business implications and should be viewed strategically.   When a business owner is considering adding staff they should consider these eight strategic questions.

  1. What would be the business impact if you did nothing? If the new position wasn’t filled then what?  Could it wait until the company is in better financial position to absorb the increase? Just because you want to hire someone doesn’t mean you have to or should.
  2. Will hiring the new person place the business in a negative cash flow (cf)? If so, for how long and how will the business fund the negative cf (working capital, infusion of a cash investment, delayed accounts payable – e.g. Vendor funded).
  3. How  does the new position support the business’ strategic objectives? Which short or long range objective will the new position help address. Often a business owner will hire someone that they believe is talented and will have to create a position for them.  Michael Jordan proved that talent doesn’t always translate across all sports. So, just because someone is talented, doesn’t mean they will be successful in your particular industry. Or even good at meeting the particular business need.
  4. Does the additional position help to eliminate or avoid a cost? If so, the cost should be quantifiable and have a payback period of 1 -3 years. Preforming this payback analysis will let you know when the company will recover from the negative impact?
  5. What is an  alternative use of the funds: Savings, Loan/debt reduction, or a capital project (equipment, repairs, etc)? This is the opportunity cost for hiring the employee.  There isn’t a such thing as free money. $35,000 spent on a new employee is money not invested elsewhere. Other investments could have a higher return on investment (ROI).  Consider the alternative investments such as a new product launch, plant expansion or investing in reducing employee turnover via raises and bonuses. Determine if hiring the new employee has a higher priority.
  6. Can the postponed investment wait to a later date? What is the impact of delaying the alternative investment?  Remember point #2. The alternative investment could have been the reducing accounts payable. Slow paying a vendor could damage the long term relationship.?
  7. What is your recourse if you determine the new employee was a bad hire? Is the new hire under a contract that can be terminated?  Does the employee know that employment will be on a trial bases? Are you prepared emotionally to release the  person if the business assumptions don’t come to fruition?
  8. Have you meditated on the decision? Do not act until you have peace about the next steps.

SummaryNow Hiring

Never rush into any decision without counting the cost. Especially, when it comes to hiring employees. Entrepreneurs deal with risk every day and are very optimistic; however, employees are not always as optimistic  (if so they would be the Entrepreneur.) Employees don’t always  have faith that things will get better and may not be prepared to recover for a bad business decision.

When considering these eight points you are doing  your due diligence and you should be comfort with now making a hiring decision.

Author: Manch Kersee, Jr.