After a long holiday period when most people put business thoughts on the back burner, it’s time to get back to work again. With that in mind let’s gets a conversation going on retained earnings; that is, what it is and what is it good for.
What Is Retained Earnings? Retained earnings is of course the amount of profit you have accumulated in the business and not distributed to the shareholders. It is the sum of how much money you have made since the company was started and not taken out in the form of dividends. It may sound like a boring concept that only your CPA should be interested in, but has some rather important ramifications for the way you can operate going forward. At today’s historically low interest rates, it is a good idea to borrow assuming that your rate of return is decent and you can then finance your growth with cheap money.
What is it good for? Retained earnings allow you to borrow money from the bank. The bank is interested in their degree of risk in lending money which is called debt. One of the ways they measure their risk is how much risk you are taking relative to them taking, i.e. their debt. Your risk is the equity you have in the business which is your retained earnings plus whatever capital contribution was made. For many companies the retained earnings portion is the larger portion. This is known as the debt to equity ratio. If you have a negligible amount of equity and you are asking for the bank to carry the lion’s share of risk it is not likely you will get the loan. Although this ratio varies from industry to industry, and loan restrictions are tighter then before, most banks are looking to take on no more then a 2:1 ratio; that is where they loan $2 for every one $1 in equity, industry ranges go from 0.5 to well above 2, although there are many factors to getting a loan and you would do well to check with you bank to determine what kind of D/E ratio and other conditions that want in order to grant you a loan and then shop around to determine your best option.
Retained earnings also gives you the ability to use your internal cash to finance growth and shore up existing operations without relying on borrowing more then you would like. Say for example that you would like to use your line of credit to finance higher accounts receivable as many companies do. You can then use a combination of your current profits and your retained earnings for other things, such as: open new offices, hiring staff, increase fixed cost, buy equipment, increase inventory and supplies, etc.
We welcome your questions as to the challenges you face in order to grow.
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