Managing profits & cash: A framework for Retained Earnings
what is it, why it matters, and how to manage it
When I think “retained earnings,” I can imagine all the non-financial eyes rolling up into their heads.
In today’s newsletter, I’m going to teach you:
- What it is
- Why it matters
- How to manage it
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Managing profits & cash: A framework for Retained Earnings
Whether you realize it or not, when a business makes a profit, a decision has to be made:
Do I redeploy this money in the business or take it out?
Money that is left in the business is known as retained earnings.
To understand retained earnings, let’s first start with profits.
Profit is the difference between Revenue and Expense in a business.
When generating a sale on a good or service, the value received (revenue) was greater than the costs associated with the unit and overhead (expenses). That’s called value creation, and what creates profits.
After generating that value, the business and business owner have to decide what to do with those profits. They can:
- Reinvest it back into the business
- Take out dividends
Retained earnings is the amount that’s reinvested back into the business.
The retained earnings account is in the Stockholder’s Equity section of the Balance Sheet and is a “running total.” This means that the balance of retained earnings grows over time, as this account accumulates a balance each year that the company is in business. Profits increase this balance and losses decrease it.
So, when looking at profits and retained earnings, how should you “use” these funds?
First, there is a “base” level of funds you should have for operations.
Second, there is reinvestment of your funds.
Third, you need to fund your growth.
Let’s talk about these 3.
Base funding needs
If we want to compare this to personal finances, this would be your “emergency fund.” To get to an emergency fund for a business, you need to understand:
- 2-4 months fixed operating expenses
- Any fluctuation in cash as a result of seasonality
- Replacement capital expenditures on the horizon
For the 2-4 months you’ll come up with a range.
Next, look at each month’s balance during a 12-month cycle and pick out the lowest and highest months.
Next, review the remaining months to see how your cash moves during the year. If there is more than one “valley,” your business is probably more seasonal and easier to predict. If there are multiple “valleys,” it’s likely your business is less predictable.
Then, compare the fluctuations and set a low-end cash target for your lean months. This should then be used to build your cash target for today.
Last, based on current operations, figure out the potential capital expenditures needs. If you have expensive equipment that could break, you need to understand how you’ll replace it.
Once you understand your base cash needs, consider how you want the business to grow.
Do you need to invest in new equipment or initiatives to take the next step as a company?
If so, it’s time to make a plan.
Each piece of equipment should be researched.
Each initiative should have its own budget and cash flow.
To grow a business, you need money. We’ve talked about the Cash Conversion Cycle in previous newsletters, which better explains the movement of cash in a business.
Grow too quickly and you could:
- Be unable to pay payroll
- Pay basic overhead expenses
- Replace inventory, thus running out.
If something can go wrong during this period, it usually does.
A reliable client slow pays.
The inventory you bought and paid for gets delayed.
Your equipment breaks.
Until you’ve experienced it first hand, it’s hard to know the feeling.
We’ll have to break down the mechanics of how to measure cash needs for growth at another time, but this is when it’s key to have a good accountant or FP&A person at your side.
Pulling money out of the business
Once you understand the cash needs from the three areas above (base funding, reinvestment, and growth), you can start talking about pulling money out of the business.
Now, a real quick note: there may be a balance in retained earnings, but unless the cash is there, you can’t pull money out. At the root of it, you’re pulling out cash.
So, with the 3 variables above, you’ll establish a cash need.
Any cash in the account over the need is cash that can get pulled out, if you decide that’s the right choice.
Owners generally pull money out to:
- Pay for taxes
- Make an outside investment
“Life” and taxes are immediately consumed, thus there is no true analysis to do.
When making outside investments, it’s always good to ask: should I use the money inside the company or outside the company?
Often, business owners default to leaving the money in the company. But, if the return on your money isn’t good, it might be better to make an outside investment.
To “know” the right choice, you need to understand your return.
Depending on the type of business you have, you could use the following formulas:
- Return on Assets (ROA)
- Return on Equity (ROE)
- Return on Invested Capital (ROIC)
- Return on Capital Employed (ROCE)
You want to calculate this return for the business, then compare it to your options outside the business.
For each person, the flavor of outside investment will look different. Real estate, the stock market, or another business opportunity, are all common places to reinvest money.
Only you can know the right decision, but by doing the analysis you can make an informed one instead of taking a shot in the dark.
As is with most things in life, it also doesn’t have to be all or nothing… you always have the choice to do a combination of the three. Your approach will be informed by what helps you achieve your financial and strategic goals, both inside the company and outside it.
Only one link this week… Just finished reading the book Retail Gangster about Crazy Eddie. He got famous for his commercials then even more famous for his fraud.
It was a great read on one of the biggest scams of all time.
For Accounting folks, it is mindblowing.
For everyone else, he stays light on numbers so it’s just pure entertainment.
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See you next week,