Retained Earnings: Building a Financial Safety Net for Your Business

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The COVID-19 crisis led to unprecedented small business closures. It was a tough reminder of how important it is for business owners to properly manage their finances and build a financial safety net. Retained earnings can play a role in creating this net.

Robert Bendetti, CFO of Life Cycle Engineering and President of the Global CFO Council, explains why this is an important accounting metric to keep track of.

What Are Retained Earnings?

Retained earnings show the historical profit you’ve kept (retained) in your business. It’s income you haven’t spent on expenses or paid out as a profit dividend to yourself or other owners of the company.

When you first open your doors, you don’t have any retained earnings because you haven’t made any money yet. Then, every year you turn a profit, your retained earnings go up — and any year you lose money, your retained earnings will go down.

You can see your retained earnings value on your balance sheet, typically at the very bottom in the shareholder’s equity section. “If a small business owner is going as far down in their balance sheet to check their retained earnings, they get a gold star in my book,” says Bendetti.

Keeping a tab on this number shows that you’re truly paying attention to the financial health of your company.

How Do You Calculate Retained Earnings?

To calculate your retained earnings, you need to first calculate your net income for the year. This is your total profit (or loss) after you take your revenue and subtract your Cost of Goods Sold (COGS), expenses, loan interest and taxes. Next, subtract any dividends you paid out to yourself and other shareholders. The amount left over is your retained earnings.

“An important note is that small businesses might not be paying dividends yet. That’s usually something that happens when they graduate into a mid-market firm,” says Bendetti.

Let’s look at a practical example that answers the question: “how do you calculate retained earnings?” Sarah has been running a daycare business for three years.

  • Year 1: net income of $50,000
  • Year 2: loss of $30,000
  • Year 3: net income of $80,000

She doesn’t pay dividends, so her retained earnings would be $100,000. ($50,000 – $30,000 + $80,000).

Senior mature business woman holding paper bill using calculator, old lady managing account finances, calculating money budget tax, planning banking loan debt pension payment sit at home office table.

Should You Have a Target Figure?

When it comes to retained earnings, Bendetti doesn’t recommend setting a specific target or goal, but he does recommend that business owners try to hit positive net income with some retained earnings four out of every five years.

“Even in years when you’re doing a lot of marketing or investing in equipment, you should still aim to end up with a little bit of profit,” he explains. “Otherwise, chances are you will run out of cash at some point.”

If your business does end up with a year of loss, you should aim to follow it up with an even higher net income year than usual — that way, your retained earnings keep growing long-term.

By planning to have at least some leftover profit for retained earnings, you’ll have a buffer in case your revenue slows down the following year or the economy gets hit with another shock like COVID-19.

What Are Retained Earnings Best Practices?

“Retained earnings and profits are great, but cash is even more important for your financial safety net,” says Bendetti. “A profitable business could still bounce a check if they aren’t generating positive cash flow.”

So, while you track your retained earnings, pay close attention to how much is converting into cash. For example, Sam owns a construction business and just completed a major project. The project terms said the client has 30 days to send payment after the end of the job.

Sam’s retained earnings would be positive because he’s “earned” the income, but it’s possible his incoming cash flow didn’t grow or is negative because he’s still waiting on payment. There’s also the risk the client doesn’t pay their bill.

As you can see, retained earnings aren’t a cut-and-dry science. So here are a few things to keep in mind.

Don’t Calculate Them In a Bubble

When you check your retained earnings, Bendetti recommends comparing them against your unpaid invoices, also labeled as “Accounts Receivables” on your balance sheet. If your total retained earnings are mostly from unpaid invoices, be cautious with spending until that money comes in.

Spend Them Wisely

Once your retained earnings come through as cash, Bendetti generally recommends two approaches to using the money.

  1. Put the profits back into your business by investing in more equipment, more employee training, better software systems, hiring more staff, etc.
  2. Give some of that money to your staff (and yourself) as bonuses and motivation to do even better next year.

Save Them For a Rainy Day

While it might sound at odds with spending, saving some of your retained earnings will help build up that financial safety net. A general rule of thumb is that you should have three to six months of operating expenses saved up.

“This can save you from wild fluctuations in cash flow, like a major client wants 90 days for their payment terms. While waiting to collect, you can keep paying your bills from this reserve,” says Bendetti.

In terms of balancing spending and saving, Bendetti recommends a 50/50 split. Put half of your retained earnings toward investing in your business now and the other half toward strengthening your financial safety net.

What Are Common Pitfalls With Retained Earnings?

There are two main pitfalls when it comes to retained earnings. The first is simply not having them. We’re talking about the businesses that break even year after year. They’re in a risky position because if revenue declines, they won’t have anything to fall back on. However, committing to building a financial safety net is easier said than done.

“In bad times, business owners all agree with the conservative principles I’m sharing,” says Bendetti. “It’s in good times that everyone gets exuberant and overconfident. They act like there will never be bad times again and spend all the money on new cars, uniforms, logos or even sponsoring a golf tournament.”

The second pitfall is thinking that retained earnings automatically count as cash. “It’s a step in the right direction — it’s close — but you still need to collect on the payment,” says Bendetti.

If all your retained earnings are stuck in unpaid invoices, you might not be adding any money to the bank. Pay attention to your cash flow and invoice collection practices as well as your retained earnings.

What’s the Point?

The whole purpose of running a business is to make money and profits, right? If you’re doing that, it should show up in your accounting statements with steadily growing retained earnings. If you ever want to bring on future investors or apply for a small business loan, showing this profitable trend will also help your chances of qualifying.

By following these tips and staying disciplined with your earnings, you can put your business in a strong financial position in more ways than one. And as the economy continues to bounce back from COVID-19, all small business owners understand the value of a strong financial safety net more than ever.

For more ideas on how to use this year’s profits, check out this article on National Funding’s blog.

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