Am I Retaining Enough Income In My Business?
At the end of the month, quarter, and year, business owners and executives review the profit and loss statement to determine the net income the business earned during the specified timeframe. Net income represents the earnings remaining after all expenses have been paid. Based on this, business owners may choose to distribute a portion of that income as dividends or shareholder distributions. For simplicity, we’ll refer to them as dividends throughout this blog. The remaining funds after these distributions are called retained earnings.
What Are Retained Earnings?
Retained earnings represent the accumulation of profits that the company has kept within the business since its inception, rather than distributing them to shareholders. This crucial financial metric can be found in the equity section of a balance sheet. Retained earnings serve as a funding source for future investments, such as research and development, expansion projects, debt reduction, or acquiring assets. By retaining a portion of earnings, a company strengthens its financial position, enhances its ability to navigate economic downturns, and fuels future growth. Essentially, retained earnings act as the business’s savings account.
How Much Should You Retain?
How do you determine whether you’re retaining enough earnings to meet your long-term goals? While a general guideline suggests a safe dividend payout ratio (the percentage of net income distributed as dividends) of less than 30%-35%, the best answer depends on several factors.
Long-Term Goals
If your goal is simply to earn a stable income without expansion, a higher payout ratio might be suitable. However, if you’re preparing for economic downturns, major purchases, rapid growth, or additional hiring, a lower payout ratio is more prudent.
Growth Stage of the Company
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- Stable and Mature Companies: Established businesses with steady cash flow and consistent earnings often maintain higher payout ratios, typically around 40%-60%.
- Growth-Oriented Companies: Businesses in early development stages or high-growth industries generally reinvest most or all earnings back into the business, often resulting in a dividend payout of 0%.
Financial Stability
To pay dividends, a company must have sufficient retained earnings and cash reserves. If earnings were negative for the year, retained earnings will decrease. A company’s financial health, ability to meet debt obligations, and overall financial commitments will impact its dividend payout decisions.
Striking the Right Balance
As you can see, long-term goals are just one consideration when determining how much income to retain versus distribute as dividends. A business must balance rewarding shareholders while ensuring financial stability and future growth. An appropriate payout ratio supports investment in new opportunities without straining the company’s resources.
By reviewing these factors, business owners can make informed financial decisions that support both immediate needs and long-term success.
Become a client and see your dreams of owning and running a profitable and successful business become a reality.
Joy Lutz, CPA, CTP
I help our client’s keep more money in their pockets by implementing proactive tax strategies.
I promise you, working with a CPA and Certified Tax Planner can be much more exciting than crunching numbers and reviewing last year’s taxes.
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