People are in business to make a profit. The question remains how best to access those profits? At the end of each financial year, or better still, just before the end of each financial year, you should make a decision about the distribution of profits.
Your options for distributing of profits include:
Retain the funds in the business as working capital
Retire external debt
Distribute income to the owners
Invest in superannuation in the names of the owners.
As your business grows and prospers over the years, its profits add to your equity (value) in the business, unless you withdraw those profits.
For most businesses, the most important source of new equity funds is the profits earned by the business which are often ploughed back into the business. The basis of this decision is that business owners believe they can increase their own wealth by utilising those funds more beneficially in the business.
Therefore, the decision about the proportion of profits which should be retained to finance the development and growth of the business, is one of the most important decisions for the business owner. There are several factors that will be relevant to the profit distribution decision.
Factors that influence your profit distribution decisions include:
- Wages/reward for the business owner
- Capital expenditure requirements
- Profitability of the business
- Amount of debt finance
- Liquidity of the business.
Be aware though that any derived income can have taxation implications, depending on your business structure.
One reason an owner might have for withdrawing cash funds from a business is to take a fair wage for time and effort put into the business.
Your business cannot make a ‘real profit’ unless it adequately compensates you for the time, skills and effort you put into the business. Therefore, you should draw a reasonable wage from the business.
You should consider these factors in determining a reasonable reward for your efforts:
1. The wage that you could earn as an employee given your education, training and experience and the type of work you are doing in your business
2. The wages businesses pay to managers
3. The wages that you would have to pay another person for doing the exact same role and to the same level.
Excessive drawings from the business are often a major reason for business failure, so you should probably choose to draw the lowest of the three figures above. It is always better to have some spare cash left in the business.
One suggestion is to draw a set amount that you consider to be reasonable based on the comments above and your personal living expenses.
Capital Expenditure Plans
The capital expenditure you would like to undertake on new assets or replacing existing assets, determines the amount of new finance your business must raise.
Keep this in mind when deciding about profit distribution.
Likewise, if you are thinking of expanding, every dollar you have will be valuable, so in the circumstances, profit distributions may be limited.
The very nature of capital expenditure means that profit retention is paramount and should be at a level that secures the long term future of the business.
This is an important issue, particularly for those companies involved in the retail trade, where the capital injection may be significant.
Profitability Of The Business
For you to receive a distribution from the business, it generally must be profitable.
Therefore, it is advisable not to make a ‘profit’ withdrawal from your business unless it has accumulated sufficient profits. Otherwise, the withdrawal will be made from your working capital, reducing the financial viability of your business.
However, it is not just the amount of profits that are important, it is also their stability from year-to-year.
If your business profits fluctuate widely, you should retain a higher proportion of profits to build up cash reserves to meet unexpected expenses or profit shortfalls.
If your financial commitments are low and/or your profit record is steady, then you can safely distribute profit to the owner. However, it is always advisable to retain a ‘buffer’ for unexpected expenditure.
Amount Of Debt
If your business is operating profitably, it may be opportune to retire some debt. A business can’t continue to indefinitely borrow money. Sooner or later the bank or other financiers expect the money to be repaid, usually from retained profits.
If you can ‘prove’ to yourself that the level of borrowing is needed and the returns are flowing, then retiring debt may not be as crucial.
Common sense suggests that your withdrawal of funds should be limited if you have made considerable use of borrowed money. It may be ‘risky’ to distribute and live excessively off borrowed money.
On the other hand, if debt has hardly been used at all, it may be possible to distribute more profits to the owner and to borrow the funds required for growth in the business in the future.
Every business is different and every person’s needs differ. It is always advisable to take a conservative approach when distributing funds if borrowings remain in the business.
When you make a withdrawal of profit from your business it is usually in the form of cash in order to meet living expenses.
However, profit in your business does not necessarily equal accumulated cash (eg. your debtors may be high), therefore accumulated profits are merely one factor that is required for an owner to make a withdrawal of profits.
The business must also be liquid: it must have enough cash to make the payment without causing cash flow problems later for the business. The availability of cash is the most critical element to a business.
Again, common sense suggests that you only distribute funds that you have available. Do not overextend the liquidity of the business for the sake of profit distribution.
Maintaining Growth And Control
With ownership of your business comes control. However, your business may reach a point where there is a need for further equity injection (eg. due to planned expansion) and you are unable to meet these demands from your own personal financial resources.
In such circumstances, you are faced with the decision of either passing up the growth opportunities for the business, or bringing in new equity. That is, introducing a new party as an equity investor.
Therefore, if you have no more personal funds available to put into the business and expansion through equity is the most viable alternative, then you should consider allowing outsiders to contribute capital in exchange for a stake in ownership of the business.
This is obviously a significant and an important decision as to the future direction and ownership of your business. If equity injection is a serious consideration, you should discuss this proposal with your accountant or legal adviser.
You will need to discuss your equity alternatives, formulate an appropriate plan to raise funds and undertake the necessary steps to raise the equity.
If done successfully, your business should be more financially secure. However, the ‘cost’ will be reduced ownership in the business, but at some point in time, most businesses must leverage to grow the business.
The level of equity rising depends largely on your finance needs and expansion plans.
Given a variety of circumstances outlined above, it is difficult to quantify the ‘required’ amount of profits that should be retained in a business.
It varies considerably from business to business. In the final analysis, common sense should prevail and the liquidity of the business is obviously the most important factor.