4.4 Capital requirement calculation

Introduction

The calculation of the capital requirement is determined by the way in which the capital is used. A distinction can be made between:

• Fixed assets (e.g. investments) are calculated by adding the acquisition costs incurred for the goods in the fixed assets, e.g. machinery, equipment, start-up investments.
• Current assets (e.g. inventory turnover) are determined by multiplying the commitment period of the current assets by the average daily expenditure on them and adding the results:
• Total capital requirement (e.g. liquidity forecast) is determined from the difference between expenditure and income over time. In other words, by adding up the fixed capital and working capital requirements.

4.4.1 Investments

Investing means investing capital for a specific purpose. The term "investment" (Latin: investire = to clothe) means the "clothing" of the enterprise with assets for the purpose of enabling the performance process within the enterprise. Investing is thus a core function of all economic activity.

The investment can be interpreted as a disbursement for the procurement of goods, the utilisation of which is expected to generate cash inflows that (significantly) exceed the disbursements in the long run. The success of investments is uncertain. Whether an investment is advantageous from the perspective of an entrepreneur depends on his expectations of profit and return as well as his willingness to take risks.

Investments are made in fixed assets such as land, buildings, machinery, financial investments on the capital market, research and development, as well as in acquisitions that are used for the longer term to fulfil operational purposes, e.g. trade fair stands for advertising, marketing concepts, licences or rights.

Any disbursement that is associated with the expectation of generating future cash inflows can be described as an investment. However, such a broad term for investments is only of limited use. Therefore, only those disbursements that result in longer-term utilisation potentials or asset positions, such as acquisitions or investments on the capital market, should be described as investments.

Investments must be economical. The amount of capital must be fixed in such a way that it is economical in the long run, i.e. it yields more return than it costs.

Justify investments

• Why is an investment necessary? 
• What equipment, plant, machinery or facilities does the company need? The quality and the customer benefit are to be determined.
• Which equipment, etc. is the cheapest for the company?
• How should the equipment, etc. be utilised? The degree of utilisation is to be determined, capacity planning is to be carried out.
• At what time is the equipment needed?

How can the necessary capital for the investment be raised on time?

 

Types of investment

Investments can be distinguished:

Performance readiness investments: new investments when starting or expanding a business, replacement investments when machinery is lost or worn out.

Investment in tangible assets: Creation or modification of material performance potential in fixed assets (e.g. purchase of machinery) or in current assets (e.g. stock replenishment). According to the investment motive, they are further subdivided into construction, expansion, rationalisation, conversion, diversification, safeguarding and replacement investments.

Intangible investments: Creating or changing intangible performance potential (e.g. capital commitments for patents, licences, product research, process research, personnel development, organisational development, marketing).

Financial investments create capital commitments with which participation or claim rights are acquired, either in order to generate the highest possible return with a defined risk or in order to draw benefit from the financed company, e.g. by influencing its business policy or to secure a cooperation.

Economic efficiency of investments

When planning investments, economic efficiency must be examined. The focus is on the capacity and utilisation of the investment. The necessary capacities must be determined for a company. Capacity is understood to be the performance capacity of an enterprise within a certain period of time, measured in terms of production or output. It depends on the plant and machinery, the company organisation and the employees.

The type and amount of investment must be adapted to the operational requirements. The question is, what capacities are needed? 

• The maximum capacity (maximum capacity) indicates what a farm is capable of achieving. The maximum capacity cannot last in the long run if it is not expanded.
• The normal capacity indicates what the farm is capable of achieving in the long run at full capacity. It is therefore lower than the maximum capacity.
• The minimum capacity refers to the utilisation at the lower limit that is necessary in order to still be able to carry out the production or service at all.

Time

The timing of an investment must be determined according to economic considerations. The financing of an investment must be made on time. This means that at the time of acquisition and payment, the liquidity for it must be established.

In the case of start-ups, a distinction must be made between the time of acquisition before and after the start-up.

• Investments that have to be paid for before the foundation can be considered foundation investments, those afterwards are new or replacement investments. 
• The sum of the start-up investments can be written off in the business plan as upfront costs. This must be taken into account in the liquidity calculation.
• Investments made after the foundation of a start-up or in an existing business must be capitalised at the time of payment. This means the cash flow has an impact on the liquidity statement and the income statement. From the time of payment, depreciation is to be taken into account in the P&L with the corresponding depreciation rates.

 

Investment calculation

Investment has been defined as the acquisition of an economic good to be used in the long term. Investment is characterised by the fact that capital is used in the present in order to gain an advantage in the future. This is an expression of entrepreneurial action.

The investment process begins with the mental anticipation of an asset to be procured. Investment planning is oriented towards the company's investment goals and is the first stage, which is followed by investment implementation and control. Investment plans have a prominent role because they are used to decide whether and in which business area new projects can be organised. Investments must create the resources to realise the company's goals. 

The investment decision is of strategic importance. If institutions did not invest, they would sooner or later become so obsolete that they would no longer be able to carry out their business activities. Investment appraisal can assist in the decision-making process:

Case study: Investment calculation of an EDP system

Investments are based on a large number of forecasts. This can be clearly illustrated by the model of payment sequences: Payments and receipts are linked to each other during the useful life (Grob 1994, p 956 ff):

 

Payments

 

The liquidation value indicates the proceeds that would ultimately be realised if the IT system were sold. The sale price can be considerably lower than the book value.

Sample data:

The investment object (IT system) can be procured at a price of € 75,000. The payment is due in t = 0. It is paid from the existing bank balance (equity capital). At this point the asset is fully operational. In the investment calculation, a useful life of 5 years is planned. During this period, constant payments of € 13,500 per year are made for the maintenance of the system.

The facility should be able to train a maximum of 300 participants per year. Because the facility has the latest user programmes, the utilisation rate after the start-up phase is higher in the first three years than in the last two years. The projected development of demand could be as follows:

 

Year	t =1	t=2	t=3	t=4	t=5
Demand/participants	210	285	295	195	185

                                               

The participant-related costs should be set at an average of 200 € for materials, energy consumption, fees. They are expected to increase by 10 € per year.

The participant fee is to be € 310 per course. For further development, an annual increase of 10 € from the price of the previous year is to be assumed.

At the end of the five years, a liquidation surplus of € 7,500 should arise because the plant can be used further. All costs and revenues should result in payments out and payments in, respectively, in the same year. The payment sequence of the investment has been calculated using the above data with an Excel programme as follows (figures have been rounded for simplicity).

 

Example calculation:

Time lapse in the year	t=0	t=1	t=2	t=3	t=4	t=5	Total
Acquisition payout	75.000 €
Capacity		300	300	300	300	300
planned participants		210	285	295	195	185
Participant fee		310 €	320 €	330 €	340 €	350 €
Sales revenue = Payments received		65.100 €	91.200 €	97.350 €	66.300 €	64.750 €	384.700€
variable TN costs		200 €	210 €	220 €	230 €	240 €
variabl. Disbursements		42.000 €	59.850 €	64.900 €	44.850 €	44.400 €	256.000 €
fixed costs = disbursements		13.500 €	13.500 €	13.500 €	13.500 €	13.500 €	67.500 €
Liquidation surplus						7.500 €	7.500 €
Payment sequence of the investment		9.600 €	17.850 €	18.950 €	7.950 €	14.350 €	68.700 €

Table 24: Example investment calculation

With the investment, a total turnover of € 384,700 could be achieved in five years. The surplus would be € 68,700 after deduction of the calculated costs and plus the liquidation surplus. That would be a 17.8 percent return.

If the capital of € 75,000 were invested with a bank at an interest rate of 3.5 %, the interest would be € 13,125 in five years. The investment shows a much better result.

Of course, the financial reality in business is more complex. Especially when the investment capital has to be borrowed from a bank. As borrowed capital, it must be serviced from current income. Taxes and duties are also incurred. Such a further consideration can initially be neglected in a business plan.

4.4.2 Capital appropriation - overview

		Time	Appointment	Afa	Afa
Capital appropriation in euro	Total Sum	Before Foundation	After Foundation	Duration in months	Amount monthly
Performance readiness investments (1)	Euro	Appointment	Appointment	Months	Euro
Machines: Production machines, packaging machines, special machines	10.000 €	7.500 €	2.500 €	60	167 €
Vehicle fleet: Company car, truck, van, delivery van	Euro	Euro	Euro	Months	Euro
Business equipment: IT software & hardware, interior design, office, warehouse, traffic routes, reception, outdoor facilities,	Euro	Euro	Euro	Months	Euro
Company website Image brochure, initial advertising, company signs, logo development	Euro	Euro	Euro	Months	Euro
Patent, licence, franchise fees Concept development costs	Euro	Euro	Euro	Months	Euro
Other	Euro	Euro	Euro	Months	Euro
Sum from (1)	Euro	Euro	Euro	Months	Euro
Investments for the production of services (2)
Raw materials, consumables and supplies, intermediate products, finished products for further processing	Euro	Euro	Euro	No depreciation,	Euro
Warehouse initial equipment,	Euro	Euro		No afa	Euro
Other	Euro	Euro	Euro	Check	Euro
Sum from (2)	Euro	Euro	Euro	Months	Euro
Foundation costs (3)	Euro	Euro		Check afa	Euro
Consulting, concept development	Euro	Euro	Euro	dto.	Euro
Notary	Euro	Euro		No afa	Euro
Registrations/entries	Euro	Euro		No afa	Euro
Education and training costs	Euro	Euro	Euro	No afa	Euro
Deposits for rent	Euro	Euro		No afa	Euro
Preliminary costs to cover the Liquidity gap	Euro	Euro		No afa	Euro
Other	Euro	Euro	Euro	check	Euro
Sum from (3)	Euro	Euro	Euro	Months	Euro
Total capital requirement from (1-3)	Euro	Euro	Euro	Months	Euro

Table 25: Capital appropriation

The list of capital utilisation indicates a broad spectrum of possible uses. The founder must find out about this individually, in relation to the respective business plan, and make an economic decision.

For each investment, a decision must be made beforehand as to whether it is necessary, whether it will yield the hoped-for economic return, or whether another type of acquisition is possible. For example, the purchase of a motor vehicle that is used exclusively for company purposes is currently cheaper to procure through leasing than to finance with one's own capital. This can mean that the acquisition of a motor vehicle is necessary, but that it is not represented as an investment in the capital requirements calculation, but must be taken into account in the ongoing operating costs in the form of a leasing instalment. The consequence of this is a reduction in investments and thus a reduction in the necessary financing with equity capital or borrowed capital.

Comparable considerations should be made when it comes to necessary business equipment that could be financed by a manufacturer, trader, licensor or a third party. Equipment investments in a restaurant could, for example, be provided by a brewery for a rental fee.

4.4.3 Raising and securing capital

Raising capital is a prerequisite for founders and companies to be able to realise a business at all. The following table can be used to check and determine what capital is needed and what collateral is available for it.

Example equity capital

Raising capital Euro	Total	Date before foundation	Date after foundation
Existing equity capital
Cash assets	10.000 €	10.000 €	€
Bank balances	20.000 €	20.000 €	€
Contributions in kind necessary for operations	5.000 €	€	5.000 €
Own work, e.g. car, licence (if capitalisable)	€	€	€
Loans to relatives	5.000 €	€	5.000 €
Donations	5.000 €	€	5.000 €
Total equity	45.000 €	30.000 €	15.000 €
Building loan contracts*	Only conditionally EK
Life insurance*	Only conditionally EK

Table 26: Raising capital

The sum of equity capital should not be less than 10 - 20 percent of fixed assets. Once the amount of equity capital has been determined, it is necessary to establish how high the borrowed capital must be, measured against the total capital requirement.

*Bauspar contracts or life insurance policies represent a special form of equity capital. As a rule, building savings contracts are not immediately available and must be used for the specified purpose - provided they are endowed with public subsidies. In principle, only the savings contributions paid in are equity capital. In the event of an early payout, only the savings contributions paid out would be capitalisable. However, if a property or land is to be acquired for a business, the disbursable savings amount could be accepted as equity. Interest and repayment would be recognised as current business expenses. In addition, building savings contracts can serve as collateral.

 

Example debt capital

Raising capital Euro	Total	Date Before foundation	Date After foundation
Required debt capital
Loans for start-ups	50.000 €	50.000 €	€
Loans from special subsidies	10.000 €	€	10.000 €
Funding from private third parties	€	€	€
Overdraft	5.000 €	€	5.000 €
Supplier credit	2.500 €	€	2.500 €
Change	€	€	€
Total borrowed capital	67.500€	50.000 €	17.500 €

Table 27: Debt capital

 

Support programmes

Money from public funding programmes plays an important role in raising capital when starting up a business and also afterwards. The federal government, the Länder and the EU support the start of entrepreneurial self-employment through funding programmes. This is especially true in the new federal states. These are mostly loans, but also non-repayable grants. Typical features of public development loans include favourable interest rates, long terms and often a repayment-free period of up to three years until repayment must begin. This means that during this time they are free of interest and repayment.

The federal government's promotional programmes are offered by KfW Mittelstandsbank. There are additional advisory institutions in each location:

• ERP equity assistance programmes (EKH): http://bmwisoftwarepaket.de/InfoArchiv/1356,1375/3023.html
• ERP start-up programme: http://bmwisoftwarepaket.de/InfoArchiv/1356,1375/3024.html
• Entrepreneur Loan DtA-StartGeld: http://bmwisoftwarepaket.de/InfoArchiv/1356,1375/3021.html
• DtA microloan: http://bmwi-softwarepaket.de/InfoArchiv/1356/3234.html
• Consultancy funding: http://bmwisoftwarepaket.de/InfoArchiv/1354/2952.html

Other funding programmes

• Investment allowances
• KfW Capital for Work Programme
• Special depreciation allowances and capital allowances to promote SMEs
• Investment grant (joint task "improvement of the regional economic structure")
• ERP-Beteiligungsprogramm, ERP-Innovationsprogramm u. a., Beteiligungskapital für kleine Technologieunternehmen (BTU),

Advice is worthwhile, it does not have to be expensive. Without advice, a lot of money can be given away.

Applications for public funding must be submitted to the house bank before the start of the project. Financial commitments may not be entered into beforehand. No subsidies will be granted retrospectively (exception: investment allowance).

Prerequisites: Funding through public financial assistance - especially for start-ups - requires that the applicant can prove that he or she has sufficient professional and commercial qualifications. In addition, it is usually expected that the business start-up will lead to a sustainable "full-time existence" as the main source of income.

Collateral

Once the amount of debt capital has been determined, it must be examined which collateral can be offered to a lender. It is up to the lender to decide which collateral to accept.

 

Raising capital Euro	Total	Date before foundation	Date after foundation
Existing collateral
House and land ownership	€	€	€
Building savings contract	€	€	€
Life insurance	€	€	€
Personal guarantee	€	€	€
Indemnity bond of a bank	€	€	€
Total collateral	€	€	€

Table 28: Loan collateral

 

• The collateralisation of house bank loans is influenced by the type and reliability of the creditor in his previous monetary transactions with the bank. Those who have always met their payment obligations on time in the past have better chances than those who have fallen behind with their payments.
• Collateral for house bank loans can be provided by transferring the company's assets as security to the lender. If the fixed assets are not sufficient, personal guarantees of the entrepreneur are common. The personal guarantee overcomes the limitation of liability, e.g. of a limited liability company, for the bank.
• The collateralisation of house and land property may be appropriate for longer-term loans. The amount of collateral is based on the market value of the property.
• Life insurance policies can serve as collateral for long-term loans, e.g. real estate.

 

Guideline value for lending limits

Land	30 - 80 % of the market value
Bank balances	100 % of the nominal value
Life insurance	100 % of the surrender value
Customer receivables	to the public sector up to 90 % of the claim amount
Customer receivables	Against other customers 30 - 50 % of the receivable amount
Customer receivables	For tax refund claims up to 100 % of the refund amount
Securities	Federal treasury bonds up to 90 % of the nominal value
Securities	Public debt securities 60 - 90 % of the market value
Shares, equity funds, bond funds, certificates	30 - 70 % of the market value
Guarantees	Depending on creditworthiness and assets
Warehouse	30 - 50 % of the cost price
Shop fittings	30 - 50 % of the current value
Machinery and business equipment	30 - 50 % of the current value
Cars	30 - 50 % of the current value
Precious metals	50 - 70 % of the metal value

Table 29: Guideline value for lending limits

 

Every founder and entrepreneur must determine his or her capital needs:

Example capital requirement

Total capital Euro	Total	Date before foundation	Date after foundation
Equity	20.000 €	15.000 €	5.000 €
+ Debt capital	67.500€	50.000 €	17.500 €
= Total capital available	87.500 €	65.000 €	22.500 €
Total capital required	75.000 €	65.000 €	10.000 €
= Surplus/shortfall	12.500 €	0 €	12.500 €

Table 30: Capital requirements

4.4.4 Working capital

Working capital is defined by the tangible assets held as current assets. These include:

• Inventories such as raw materials and supplies, finished goods, work in progress and merchandise.

Setting up and building up a warehouse to start a business can be considered working capital. It must be pre-financed as part of the start-up investment.

The importance of inventory is huge, particularly for manufacturing companies, especially in terms of delivery times and customer orientation.

Stocks should be large enough so that the business can always produce and deliver. However, they should not be higher than required for the economic operation of the business. Too large stocks deprive the business of liquid funds, increase interest, storage costs and the risks of spoilage, shrinkage, theft, fire, obsolescence and price decline. Stocks that are too small jeopardise sales or production readiness and may require low-priced, urgent orders.

Depending on the storage volume, the capital commitment can be of great importance for the company. The stock or goods turnover is to be determined within the framework of the calculation of working capital. The higher the turnover rate, the lower the capital employed.

 

The turnover rate is calculated as the turnover coefficient in terms of volume and value:

 

Turnover rate:

Quantitative =	Cost of sales (quantity)
	Average stock
Value =	Cost of sales (Euro)
	Average stock
Storage period =	360 days
	Turnover frequency (days, months...)

Table 31: Turnover rate

 

Within the framework of capital procurement, it must be determined for what purpose and in what amount current assets must be invested.

Other current assets:

• Trade receivables, which are, for example, goods, products or services that have been delivered to customers but not yet paid for.
• Receivables from affiliated companies, e.g. in a holding company or public limited company,
• Receivables from loans given by the company to third parties, e.g. suppliers.
• Bills of exchange that have been issued but not yet honoured,
• Cash on hand, balances with banks and institutions,
• Securities, shares,
• When determining the capital requirement from the current assets, it is particularly important to take into account the liabilities to third parties. Liabilities can be differentiated:
• Liabilities to credit institutions (loans, loans from development programmes, etc.)
• Trade payables that the company still has outstanding.

The receivables are to be compared with the liabilities in order to be able to determine the capital requirement for the current assets.

4.4.5 Total capital requirement

The total capital requirement results from the difference

• of the available equity and the required debt capital for the financing of fixed assets (including start-up financing),
• in current assets from the necessary turnover of goods as well as from receivables and liabilities.

The capital requirement results when all income is deducted from expenditure.

Revenue	Turnover + other income
- Expenditure	Investments + Operating expenses + Liabilities - Receivables
= Capital requirement	Difference in euros

 

Calculation method

To be able to determine a funding gap, the monthly income must be subtracted from the expenses. The difference results in a profit or a loss. The profit and loss account or the income statement determines this data constantly.

In the following example, the capital requirement of an entrepreneur in January is € 1,000. Because the expenses do not cover the income, the capital requirement temporarily increases to a maximum of € 5,000; it amounts to € 3,000 in June. By the month of March, the company actually needs € 5,000 in additional capital to meet its obligations. If the money is not available then, insolvency is imminent. The maximum financing gap must be determined.

Calculation scheme for the capital requirement

Month Total of all Expenditure Total of all Revenue Capital requirement as Difference between income and expenditure: Totals are accumulated. January 1.000 € 0 € -1.000 € February 2.000 € 0 € - 3.000 € March 3.000 € 1.000 € - 5.000 € April 1.000 € 2.000 € - 4.000 € May 2.000 € 2.000 € - 4.000 € June 1.000 € 2.000 € - 3.000 €

 

 

 

 

 

 

 

 

 

 

 

 

The accuracy of the capital requirements calculation depends on the available operational data. The more complex business units are, the more differentiated the capital requirement calculation must be. Simple rough calculations do not go far enough.

4.4.6 Calculation of financing and liquidity gaps

When determining capital requirements, it is necessary to establish what needs to be invested and financed. Here the table on capital utilisation provides a comprehensive overview.

Financing is about how? What capital should be used to pay for the investments and the costs?

When working on a business plan, financing and liquidity gaps are particularly critical items.

• If the tangible investments are relatively easy to determine, the determination of the upfront costs is a special aspect.
• Pre-investment costs of the foundation can include investments in kind as well as fees and contributions. Overall, they can be financed as investment costs.
• Particularly in the case of start-ups, initial losses occur that lead to a liquidity gap. Preliminary costs to cover the liquidity gap can be financed as investment costs.

In economic terms, the issue of investment financing via equity and debt capital must be distinguished from the issue of depreciation.

While investments in tangible assets can be written off in full as business expenses with a defined term, start-up costs are only deductible as business expenses to a limited extent. This is to be decided in the individual case. 

 

Summary

In this study letter on business accounting and financial planning, you have dealt in detail with the topics of cost planning, cost accounting, calculation, pricing, financial planning and capital budgeting.

In the previous study letters, it was discussed how you can prove the marketability and market opportunities of your company. This is, of course, the most important factor for the success of a company, because without products that the market wants, you cannot achieve turnover and also profit. And that, after all, is the overriding goal of a business. But even the best business or product idea will disappear into oblivion in the long run if it is not based on a solid financial foundation.

It is therefore important to define very precisely what costs you will incur. If you know what your cost structure is, you will also know how many products you have to sell per month to cover the costs. And how many more products you need to sell to make a living.

Closely connected to this is the calculation of your products. What price do you have to charge to cover your costs? And are the customers willing to pay the calculated price? It gets complicated when you have many different products. Then you have to determine which product causes which costs and what price it must have.

Within the framework of financial planning, you must justify where the money for your business will come from and how you want to use it. Do you have equity capital that you want to put into the business? Do you need to take out a loan? How much capital do you need to cover? You probably won't be able to get around a loan. The decisive factor here is that you use the money in such a way that you can make the debt service, i.e. that you can pay your instalments and still have something left over at the end of the month. In order to make an assessment, it is of course also necessary to know how you are using the capital. A company car is all well and good, but you won't earn money with it alone. If you have built up a great business with nice salesrooms, but you have no money left to fill your shelves with goods, you have gained nothing.

How much money you need in total to set up and maintain the business is determined in the capital requirements calculation. What does it cost to set up the business, how much money do you need for goods and what are the running costs for rent, etc. are the relevant questions. From this, the total capital requirement must be determined.