Most business owners manage their business with the goal of growing over time. In order to do this, it is important not only to ensure expenses and investors are paid but also that you are properly investing back into the business. However, managing business income properly will mean continually reassessing the business’s position, and when to strategically invest in growth opportunities. Below, we discuss a business’s retained earnings, and how to make the most of them through reinvestment back into the business itself.
What are Retained Earnings and How Should They Be Managed?
Retained earnings are defined as the portion of a business’s income left over after its debts have been paid. The debts may include items such as vendor accounts, shareholder dividends, payroll, etc. While keeping these earnings in the bank may be tempting, growing a business means that it is equally important to invest a percentage of the earnings back into the business.
Part of your business strategy should involve making the best use of your retained earnings not just to stay competitive, but to grow. For this reason, it is wise to invest retained earnings into improving your company’s competitive advantage by acquiring better equipment, real property, or additional employees. Essentially, you should be investing in ways to make your business more efficient, to increase production or services, or to reach a larger audience.
The “Return on Retained Earnings Ratio”
Before getting into how to manage retained earnings, let’s talk about the Return on Retained Earnings Ratio (RORE). This refers to the percentage of a business’s earnings that are invested back into the business in relation to earnings that are paid out as dividends or elsewhere. Return on retained earnings is a calculation that shows the portion of a company’s profits, after dividend payments, that are reinvested into the business and are often an indicator of a company’s growth potential. A high RORE indicates that a company can better serve its investors by putting an emphasis on internal growth rather than by paying dividends. When a company is in a period of significant growth, investors may be willing to pause or lower dividend payouts in exchange for a higher return down the road.
Conversely, a low RORE could indicate that a business is in a low growth period and the investors are better served by immediate earnings as opposed to reinvestment.
Managing Retained Earnings
In most cases, a growing company will manage retained earnings by investing back into the business or by buying other businesses. This decision will generally be acceptable to shareholders as it will generate increased profits which makes the company more valuable in the long run, increasing their future profit. As mentioned earlier, as long as these investments are used to develop a durable competitive advantage, your business’ value will increase.
As your business evolves and grows, you will have other choices. If your company is publicly traded on a stock exchange and its share price has plateaued, you may want to pay some dividends to your shareholders rather than reinvesting. Paying out dividends reduces the retained earnings in the company which helps it to attain the desired return on equity.
Reducing Retained Income to Elevate a Business’s Value
Another option to increase the value of a mature, publicly-traded business is to buy back shares from current common shareholders. While this may seem to be an unorthodox recommendation, it can be beneficial to the company’s value. Companies are often evaluated on Earnings per Share (EPS) and Return on Equity (ROE). If a company has generated a surplus of cash due to years of strong profitability (the retained earnings have not been invested in projects), this cash can be used to buy shares back from the current common shareholders. The calculation of EPS is Net Income Available to the Common Shareholders divided by the number of common shares held by shareholders. If the number of shares held by common shareholders decreases, then the EPS increases, placing the company in a better position from a value standpoint.
As for how this would impact a company’s ROE, if a company continues to build up equity (share investment and retained earnings), it needs to earn a higher net income each year to meet the optimal ROE. Buying back the shares reduces both parts of equity (share investment and retained earnings) and makes it easier to achieve the desired ROE.
Contact Sloan Partners LLP in Toronto for Guidance on How to Strategically Manage Your Business’s Income
When strategizing about the best way to manage a company’s profit, it is best to get advice from a business consultant who can assess your specific situation and provide tailored guidance.
The financial specialists at Sloan Partners LLP in Toronto will review your particular circumstances and provide ongoing, proactive advice to help you grow your business and meet your financial goals. To learn more about how we can assist you, contact us online or by telephone at 416-665-7735.