Retained Earnings

Posted by PITHOCRATES - November 12th, 2012

Economics 101

Small Business Owners often Reinvest Everything they Earn back into their Businesses

It takes money to make money.  Before a business can make any money it has to produce something that can create revenue.  That is, they have to create something of value that people will pay money for.  To do that they have to buy land, buildings, equipment, etc., first.  They have to hire people and pay wages, salaries, benefits and payroll taxes first.  They have to spend this money before they can sell anything of value.  Because there is a time delay before the money they spend can produce anything to sell they have to get money elsewhere.  To pay all the bills.  Before they can start paying their bills from their revenue.

Small business owners often use their life savings.  They may mortgage their homes.  They may borrow money from their parents.  Or from other family.  If their capital needs are small they may use their credit cards.  And work out of their homes.  But one thing is for sure.  A small business is a cash hungry beast.  And it has a voracious appetite when it’s growing.  For those who make it to this level may be able to convince a bank to loan them money.  That can fund that growth.  Others may turn to venture capital.  If they can convince a venture capitalist that they have a great idea than can really make some money.  More advanced businesses may require even greater sums of money to fund growth and turn to the capital markets.  Using stocks and bonds to fund that growth.

Of course, it takes awhile to get to that level.  Unless you have one of those great and unique ideas.  Which can accelerate a business through this growth process.  But for most it’s a longer journey to get there.  Involving a life of sacrifice.  Skipping vacations.  Eating more hamburger than steak.  And putting off the things you want (new television, smartphone, tablet, car, etc.) until you can afford them.  Which often doesn’t come for a very long time.  Instead, small business owners often reinvest everything they earn back into the business.  To help get it to the next level.  Many small business owners don’t even pay themselves.  Because their business needs that cash elsewhere.

A lot of Small Business Owners don’t pay themselves as they Establish their Businesses

So why do they do it?  It’s not for the money.  For small business owners could make more money working for someone else without all of the headaches.  No.  They don’t do it for the money.  They do it because they’re entrepreneurs.  Filled with a passion to do something better.  Or new.  Just look at what drove Steve Jobs.  It wasn’t the money.  It was all about creating great things.  Things he couldn’t stop thinking about.  Driving some of his people crazy with his relentless push for perfection.  But he couldn’t help himself.  For he felt no inner peace until he realized his vision.  Even when his engineers and designers said what he wanted couldn’t be done.  And they kept saying that until they did what they said couldn’t be done.

This is why some entrepreneurs go ‘Albert Einstein’ in pursuit of their vision.  So focused they skip meals because they forgot to eat.  Or didn’t want to waste time by stopping to eat.  Ever try to eat lunch with a small business owner?  It can be a little on the frustrating side trying to hold a conversation.  As they never shut down.  Their mind is somewhere else.  They’re thinking about something.  On the phone.  Checking email.  Scratching notes.  These are the people that keep working the phones even when sitting on the toilet.  They’re that driven.  And we’re lucky to have such people in the world.  For they make a lot of things we like.  And create a lot of jobs.  In fact, these small business owners are the engine of job growth.  For no one creates more jobs than they do.  Not even the big corporations with billions in revenue.  It’s the small business owner who does cartwheels when they break a million in revenue.  It’s the small business with 5 employees that hires a sixth.  This is where real job growth comes from.  Because there are so many more small business owners than big corporations.

The small business owner is no stranger to sacrifice.  He or she is willing to do whatever they have to.  Even going in on the weekend and working late into the night.  While their employees are enjoying their weekend.  Spending the paychecks they earned working for the small business owner.  While the owner often doesn’t take a paycheck.  Because while he or she can sacrifice things in their personal life they need cash for their business.  For employees don’t work unless you pay them.  And if the government doesn’t get their taxes they will shut you down.  This is why a lot of small business owners don’t pay themselves as they establish their businesses.  For money they take from their businesses reduces how much their businesses can grow.  And it leaves them vulnerable to large, unexpected costs that can hit their businesses.  Or to things that can cause a drop in revenue due to something beyond an owner’s control.  Like a recession.

The Higher the Regulatory Costs and Taxes are the less Small Business Owners can Retain to Grow their Business

So when it comes to cash management small business owners are conservative.  They begged, borrowed and sacrificed to start their businesses.  And incurred substantial debt to grow their businesses.  Which only provides short-term financing.  Once they burn through that money they have to replace it with money generated by business operations.  To sustain business operations.  And to pay back those loans.  For if they don’t they can lose everything they built.  Business earnings, then, are like a fire in survival conditions.  Say you’re lost, alone and cold.  The only thing keeping you from freezing to death is the warmth from that fire.   Once started (with those bank loans) the owner has to nurture and protect that fire to keep it from extinguishing.

So how does a business make money?  They sell goods and/or services for money.  Which gives them revenue.  Then they subtract all of their costs from that revenue.  Any money left over is net profits.  Or earnings.  If they leave this money in the business these earnings become retained earnings.  That they can use to pay back those loans.  Repair old equipment.  Buy new equipment.  Pay for some advertising to expand the business.  Or even hire new employees.  If those earnings are large enough.  And recurring enough.  To give them the confidence that they will be able to pay these new costs in the future.  Provided nothing unforeseen comes up to diminish their future earnings.

But there always are.  And they’re something small business owners have to think about.  All of the time.  Especially when they think about expanding their businesses.  And hiring people.  Because that adds recurring costs.  Which is why few business owners are hiring people now.  Because of the added costs of new regulations.  The big one being Obamacare.  And higher taxes.  Especially the talk of new higher tax rates on high income people.  As most small business owners have their business earnings flow to their personal tax returns.  Even if they leave that money in their business they still have to pay taxes on it.  So while the government taxes them as rich people they’re not rich.  As they see little of their earnings.  Most of which they reinvest into their businesses.  Where it becomes retained earnings.  But the higher the regulatory costs and taxes are the less they can retain to grow their business.  And the fewer jobs they can create.  Worse, these new costs and taxes could reduce earnings to the point that they can’t pay their recurring costs.  Or service their debt.  Which could cause bankruptcy.  So small business owners are very sensitive to things like new regulatory costs and new taxes.  For they can be the difference between life and death.  If they rain down hard enough to extinguish those earnings.

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