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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Capital and Capitalism

Posted by PITHOCRATES - May 7th, 2012

Economics 101

Entrepreneurs have an Insatiable Desire to Think and Create

It takes money to make money.  For it is money that buys the means of production.  The land, manufacturing plants, small shops, office space, machines, equipment and infrastructure that make things.  The trucks, barges, container ships, locomotives and rolling stock that transport raw material, work-in-progress and finished goods.  These physical assets are capital.  From assembly lines to inventory control systems to accounting software.  Things that let businesses conduct business.  And make profits.

This is the key to capitalism.  Profits.  It’s what allows businesses to make the things we need and enjoy.  Profits are what make an entrepreneur take a risk.  To spend their life savings.  To mortgage their home.  To borrow from a bank.  They do these things because they believe they will be able to earn enough profits to replenish their life savings.  To make their mortgage payments.  To repay their loans.  AND to earn a living in the process.  It is a risky endeavor.  And far more risky than working for someone and earning a steady paycheck.  But if entrepreneurs didn’t take these risks we wouldn’t have things like the iPhone or the automobile or the airplane.  All of which were brought to us because one person had an idea.  And then invested in the capital to bring that idea to market.

Some business ideas succeed.  Many more fail.  But people keep trying.  Because of that insatiable desire to think and create.  And the ability to earn profits to pay for their ideas.  To build on their ideas.  To expand their ideas.  From the first thoughts of it they kicked around in their head.  To the multinational corporations their ideas grew into.  All made possible by the profits they earned.  The more they earned the more they could do.  As they reinvested those earnings into their businesses.  To buy more capital.  That allowed them to build more things.  And use even more capital to bring these things to market.  Creating jobs all along the way.  Jobs that only came into being because of those profits that started as a single thought in someone’s head.

If you can’t Service your Debt your Creditors can and will Force you into Bankruptcy

This is where corporations come from.  From a single thought.  Profitable business operations grow that thought into the corporations they become.  For corporations are not the evil spawn of the damned.  Corporations come from people having a great idea.  Like Starbucks.  And Ben and Jerry’s.  Who are now everywhere so we can enjoy their products wherever we are.  All made possible by the profits of capitalism.

Who’s up for a little accounting?  You are?  Well, then, you came to the right place.  For we’re going to learn a little accounting.  Right here.  Right now.  Corporations determine their profits by closing their books at the end of an accounting period.  A series of accounting steps culminate in the trial balance.  Where the sum of all debits equal the sum of all credits.  Or eventually do after various adjusting entries.  Once they do the books are balanced.  And business at last can see if they were profitable.  By producing an income statement.  Which lists revenue at the top.  Then sums all costs (materials, production wages, payroll taxes & health insurance for that labor, etc.) that produced that revenue.  Subtracting these costs from revenue gives you gross profit.  Then comes overhead costs.  Fixed costs.  Like rent and utilities.  And overhead labor (corporate officers, management, accounting, human resources, etc.).  They sum these and subtract them from gross profit.  Which brings us to earnings before interest and taxes (EBIT).  A very important profitability number.  For if there is any money left by the time you reach EBIT your business operations were profitable.  Your business was able to pay all the due bills to produce your revenue.  Which leaves just two numbers.  Interest they owe on their loans.  And income taxes.

EBIT is a very important number.  For if it’s not large enough to service your debt everything above EBIT is for naught.  Because if you can’t service your debt your creditors can and will force you into bankruptcy.  Never a good thing.  And what follows is usually the opposite of growing your business.  Shrinking your business.  By seriously cutting costs (i.e., massive layoffs).  And eliminating unprofitable lines of revenue.  Downsizing and reorganizing as necessary so your cost structure can produce a profit at the given market price for your goods and/or services.  A price determined by your competition in the market.  If you cannot downsize and reorganize sufficiently to become profitable then you go out of business.  Or you sell the business to someone who can make a profit.  Because unless you can turn a profit your business will consume money.  And that money has to come from somewhere.  Typically it is the business owner until they run out of life savings and home to mortgage.  Because a bank can’t give you money to lose in your business.  For their depositors put their money into the bank to grow their savings.  Not to shrink them.  So a bank has to be profitable to please their depositors.  And if the bank is using their money to make bad loans they will remove their money.  As will other depositors.  Perhaps creating a run on the bank.  And causing the bank to fail.  So while operating at a loss will save employees jobs in the short term it will cause far greater harm in the long term.  Which isn’t good for anyone.

Capitalism works because with Risk there’s Reward

As you can see getting those accounting reports to fairly state the profitability of a business is crucial.  For it’s the only way a business knows if it can pay its bills.  And the way they pay their bills complicate matters.  Revenue and costs come in at different times.  To bring order to this chaos businesses use accrual accounting.  Which includes two very important rules.  To record accurately when revenue is revenue (for example, a down payment is not revenue.  It’s a liability a business owes the customer until the sale transaction is complete).  And to match costs to revenue.  Meaning that every cost a business incurred producing a sale is matched to that sale.  Even long-term fixed assets like buildings and machinery.  Which they depreciate over the life of the asset.  Charging a depreciation expense each accounting period until the asset is fully depreciated.

Because of these accounting reports that fairly state business operations a business knows if they are profitable.  That they can pay all of their bills.  Their suppliers AND their employees.  Their health insurance AND their payroll taxes.  The interest on their debt AND their income taxes.  They can pay all of these when they come due.  And not run out of money when other bills come due.  Which is why they can have confidence when they read their income statement.  Knowing that they paid all their costs due in that accounting period.  Including the interest on their debt.  And their income taxes.  Which takes them to the bottom line.  Net profit.  And if it’s positive they have money to reinvest into their business.  To expand operations.  To increase sales revenue.  Create more jobs.  And they can grow.  But not too much that they lose control.  So they can always pay their bills.  So they can keep doing what they love.  Thinking.  And bringing new ideas to market.

This is capitalism.  Where people take risks.  In hopes of making profits.  They invest in capital to make those profits.  And then use those profits to invest in capital.  It works because there is a direct relationship between risk and profits.  It’s why people take risks.  Create jobs.  And provide the things we need and enjoy.  Because with risk there’s reward.  And accounting reports that fairly state business operations give a business’ management the tools to be profitable.  By matching costs to revenue.  Telling them when they are not using their capital efficiently.  Helping them to stay profitable.  (Unlike anything the government runs.  Because there is no matching of costs to revenue.  Taxes come into the treasury and the treasury pays for a multitude of things.  With no way to know if they are using those taxes efficiently).  And this is capitalism.  Risk and reward.  And accountability.  For when you’re risking your money you become very accountable.  Which is why capitalism works .  And government-run entities don’t.

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