Capital management is one of the most critical tasks in any given business. Capital forms the most crucial factor of production as capital finances the other factors such as land and labor. Decision-making for entrepreneurs becomes most important, challenging, and crucial due to the resource usage of capital.
The basic form of capital consists of Equity and Debt. While Equity consists of common shares, preference shares and warrants, debt consists of secured business loans such as collateralized business loans, term loans, working capital loans, etc., and an unsecured business loan from banks and financial institutions.
Purpose of efficient fund allocation
Many businesses find it challenging to manage cash flows. Thus, the allocation of funds becomes an essential and integral part of the business. Efficient allocation of funds ensures the smooth running of the business. Capital carries a cost along with it. Allocation of capital is essential since it also reduces the cost of capital and ensures optimum usage of funds.
How to allocate the funds?
Large corporations often take the advice of professional money managers for their cash flow management and fund requirements. However, Micro, Small and Medium Enterprises (MSMEs) usually make decisions regarding money management by themselves. Thus, after raising capital, particularly the loans, the business owners must follow some basic steps to attain financial discipline. It helps the business to grow sustainably and create value for all the stakeholders of the business.
1. Planning
Planning is the first step in allocating the funds effectively, and proper planning of the cash flow management is a job half done. Business managers must identify the need for cash in the business and plan on its cash deployment strategy. On identifying the need for cash in the business and receiving the loan from the banks / financial institution.
2. Budgeting
The business owners must budget the cash flows under each head of assets or expenses. Budgeting is an essential task since it will estimate the utilization of funds required under each head. Budgeting provides better estimates under each head of expenditure, and the owners can restrict the cash flow spending as per the budgets. It helps them to avoid any overrun of costs while creating any assets of the business. A comprehensive budget with all the cash items would help the businesses efficiently allocate capital.
3. Optimum Deployment of Funds
The MSMEs shall ensure optimum utilization of the funds after receiving the funds from the banks or financial institutions and budgeting the business's cash flow needs. The banks or financial institutions might sanction the business loans considering the project's entire cost and cash requirement. However, the business owners must draw down the funds only to the extent required at a given point in time. Drawing down funds above the requirement would entail additional interest costs. High-interest costs lower the business's profits.
On the contrary, a shortage of funds may also prove costly for businesses. Companies may lose out on discounts provided by the suppliers. Business owners may also have to pay an overdue penalty on making the payment after the given credit period by the suppliers.
Businesses should also focus on reducing the cost of their borrowings. They must select the right product to suit their funding requirements. Companies can reduce their overall cost of borrowings and improve profits by doing so. Secured business loan interest rates are comparatively lower than unsecured business loans. Interest rates also depend upon the past credit history of the borrower, financial strengths, comfort on the cash flows of the business, existing net worth of the company, type and value of collateral securities, etc.
4. Monitoring & Review
Post receiving an MSME loan and utilization of the funds, owners must monitor the progress of the development of the assets and utilization of funds. Business owners must also monitor and ensure the utilization of funds for the intended purpose for which the funds are raised. Companies must utilize long-term loans such as term loans/business loans to create long-term fixed assets. On the other hand, it must utilize short-term funds such as working capital loans and unsecured business loans for the short-term liquidity requirements of the company.
Business owners must also ensure that short-term funds do not fund fixed assets as it may lead to cash flow mismatches, and the business may default on its repayment obligations. Over-leveraging is another issue that companies must avoid. Monitoring the cash flow post-deployment and periodical review of cash flows will ensure its optimum utilization and improved resource efficiency.
5. Variance Analysis
Variance analysis refers to a comparison between the actual fund utilization versus the budgeted utilization. The variance analysis helps the business find the gaps between the actual utilization of the business loans and budgeted utilization. Businesses can identify the cost overrun or money less utilized than the estimated amount, and they can also reason out the causes of such cost overrun or underutilization. Companies need to oversee whether such variances would continue on an ongoing basis or a one-time event. If the difference persists in the future, companies must revise their cost estimates and identify the future fund requirements. Variance analysis is a crucial aftermath tool.
Conclusion
The optimum utilization of funds would vary from company to company, depending upon the organization’s business requirements and financial planning. All the above activities must be practiced continuously - from planning, budgeting the cash flows, monitoring the cash flows and conducting variance analysis. Each step would help the business owners efficiently allocate the capital in the business. Raising the business loans through the right mix of products is as necessary as allocating the capital to build assets. Shriram Finance provides customized business loan solutions at competitive interest rates. MSMEs can access the best business loans through fast and secure processing, easy availability and repayment with flexible tenure for better capital management and efficient allocation of funds.
