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. The net income is the income earned after all expenses have been paid. Depending on the income earned, business owners may then distribute some portion of that income as dividends or shareholder distributions. We will call them dividends for the sake of this blog. The money that is left after shareholder distributions have been paid is called retained earnings.
RETAINED EARNINGS REPRESENT THE ACCUMULATION OF PROFITS THAT THE COMPANY HAS RETAINED WITHIN THE BUSINESS SINCE ITS INCEPTION, RATHER THAN BEING PAID OUT THROUGH DIVIDENDS.
The value of retained earnings can be found in the equity section of a balance sheet. Retained earnings play a significant role in a company’s financial structure. They serve as a source of funding for future investments, such as research and development, expansion projects, debt reduction, or acquiring assets. By retaining a portion of the earnings, a company can strengthen its financial position, enhance its ability to weather economic downturns, and fuel its growth and development. A business can think of retained earnings as a savings account for the business.
So how do you know if you are retaining enough earnings to meet your long-term goals? Generally speaking, a safe dividend payout ratio (the amount of dividends or shareholder distributions that are paid out as a percentage of net income) is less than 30% – 35%. However, the more accurate answer to this question depends on many factors:
LONG TERM GOALS
If your goal is to simply earn a living, and you do not expect growth, a higher payout ratio would be expected. However, if you are preparing for a downturn in the economic environment, a significant purchase, higher growth, and/or the hiring of additional employees, a lower payout ratio would be more prudent.
CURRENT GROWTH STAGE OF THE COMPANY
Stable and mature companies: Established companies with stable cash flows and consistent earnings often have higher payout ratios. A payout ratio of 40% – 60% is commonly considered reasonable for such companies.
GROWTH-ORIENTED COMPANIES
Companies that are in the early stages of development or in high-growth industries may need to reinvest more earnings back into the business to be able to pay for future expansion. It is common for companies in this infancy stage to reinvest all earnings, making the dividend payout 0%.
FINANCIAL STABILITY
Companies must maintain financial stability in order to pay dividends. If your earnings were negative for the year, your retained earnings will decrease. In order to make dividend payments, a company must have enough retained earnings and cash reserves. A company’s financial health and its ability to meet debt obligations and other financial commitments will influence the dividend payout ratio.
As you can see, a look at the long-term goals are absolutely necessary when deciding how much income to retain and how much to pay as dividends but other factors must be considered as well. It is important for a company to strike a balance between paying dividends and retaining earnings for future growth. A payout ratio that does not strain the company’s financial stability or hinder its ability to invest in growth opportunities while rewarding shareholders for their investment in the company is considered appropriate.
Through the Fractional CFO services at Aligned CPA, we can help you review all of these factors that will give you Peace of Mind regarding your decision to retain money in your business or pay it out as shareholder distributions.
Become a client and see your dreams of owning and running a profitable and successful business become a reality.
Cessie Cothran, MBA
Combining the CFO Advisory with tax strategy creates the best opportunity for financial success. We like to call it being perfectly Aligned. Our clients know they have us as a partner, helping them to feel secure about their financial future.