(This article appears in the November-December 2016 issue of Canadian Natural Health Retailer)
For entrepreneurs without a strong financial background, the job of capital budgeting can seem overwhelming. Capital budgeting – essentially the process of deciding how to invest excess cash within a company on items that are not regular “operational” items – covers a wide range of activities, and can include everything from purchasing a new piece of equipment to making a substantial investment in capital assets for a new location. For a business owner or manager, deciding what to do with capital is an ongoing process, and it is one of the few jobs in a company in which a business owner must be deeply involved. A business owner is, first and foremost, an investor in their own company, and therefore the return on their invested capital should always exceed the level of risk involved.
To make better spending decisions, an entrepreneur needs to become familiar with the basics of capital budgeting, and to develop their own unique approach to when and how their company spends excess cash. To be successful in this, a business owner does not need to become an expert in corporate finance, but they do need to understand the basics enough to make a good decision. Most capital budgeting models, from Net Present Value to Internal Rate of Return, are relatively easy to compute using a spreadsheet program or an online calculator – the challenge is understanding what they tell you and how to use them. Below are five crucial rules to remember when approaching this challenging but crucially important topic:
- The discipline of corporate finance will tell you that any potential cash outflow should increase the value of your company over a specific time frame. This means that if you want to spend $5000 on a new piece of equipment, then that piece of equipment should add more than $5000 of value to your company over, say, two years. Otherwise you’re just turning dollars into dollars (or worse, turning dollars into cents!).
- In order to plan your capital outflows, it is crucial to understand the flow of cash within your company. If you’re not producing monthly or quarterly cash flow statements, then you likely have little sense of how much cash is coming into or leaving your company on a regular basis. Without understanding your cash flow, it is nearly impossible to adequately plan when or how you’re going to make capital budgeting decisions.
- Not every company is created equal, so it seems logical to conclude that a capital budgeting model that works for one company will be less effective in another. It’s up to you as a business owner to develop your own unique understanding of and philosophy towards this area, and to work within the confines of that approach.
- Not every dollar that a company creates actually needs to be spent. There are many entrepreneurs out there who just can’t wait to spend excess cash on new projects. But the reality is that sometimes there are no good projects, and there is certainly nothing wrong with just sitting on cash until you find a suitable opportunity.
- Some decisions simply cannot be quantified. Despite the need for every company to have a capital budgeting methodology, every business owner knows that financial models and calculations can only take you so far, and that sometimes you need to rely on your instincts. Capital budgeting techniques are a great starting point, but they shouldn’t lock you into financial tunnel vision.