In case you missed it: Part 1 – Part 2 – Part 3 – Part 4
Profit – Return to Owners or Invest for Growth?
The fourth reason money goes out of a business is the best of all. Profit. When COGS is covered, the bills are paid, and the lenders/investors are getting their fair share, what’s left is profit. Probably why you started the company in the first place. Before I tell you how to spend profits (really, it’s not obvious – at least not completely) let me draw a distinction for you.
Owning a Business vs Owning a Job
When you own a company but don’t work there (say you buy shares of a public company) you only get money if the company shows a profit, and the board decides to give that profit to investors as a dividend. However if you work there you get money for the work you do. Most small business owners don’t really make a distinction about how they earn the money they get from their companies. But I suggest you do.
Here’s how:
Step 1. Write down how much you take out of the company on an annual basis.
Step 2. Figure out what you do for the company and what it would cost (at fair market rates) to replace what you do. You may not be able to replace yourself all in one shot. Perhaps you’d have to hire 1/2 a salesperson, 1/3 of a CEO and the rest little bit of everything. Total that all up, and assign it to the right section as if it were an actual cost. If all the money you take out comes from COGS and OVERHEAD or if it would cost you more to replace yourself in those areas than you take, then you effectively own a job.
Step 3. If you could pay to replace yourself and still there’s more money that you take out, figure out how much you’ve invested in the company and what a reasonable payback would be if you were an outside investor. That’s what you’re earning from your investment in the business.
How to spend profits
If, after step 3, you still take more money out of the company, then the company is truly showing a profit. Now you have a choice. You can take that profit out of the company and split it among the owners. This is what a public company does when it declares a dividend. Or you can reinvest that profit in the company in some way that adds capcaicty: new locations, new equipment, moving into a new market etc. If you have to put that “profit” back in the company to buy inventory (COGS) or keep the lights on (Operations) then it’s not really profit.
If you do decide to reinvest your profit, you should do an analysis like an outside investor would. Figure out how much additional capacity (sales) your new investment should bring in. What extra costs will you incur before sales reach that point? When they do, how much of the new sales will go toward new COGS, how much toward the increase in operational expenses and how much should be left to pay back your investment. After payback, how much profit will there be?
That will help you decide if it’s a wise way to spend your money.
[Disclaimer: I’m speaking here in conceptual terms. The mechanics of how you pay yourself and how you reinvest have various tax and legal ramifications. These differ with your situation and the legal entity of your company. You should consult a qualified tax and legal advisor before you take action. I am neither. Use this information just for making conceptual decisions.]
