It might seem like a peculiar question, but deciding what to do with profit happens to be one of the most important planning decisions for a small business owner. Once the current expenses of a business are satisfied, there are really only three things you can do with a profit dollar. Not coincidentally, they coincide with the three major sections of the balance sheet: Assets, liabilities and equity.
Working from the bottom up, equity (owners equity) is the section that will be impacted if you decide to take an owner’s draw. (Here we have to stipulate that this applies to enterprises not paying taxes as corporations and owners who are not W-2 employees. For corporations we would probably be talking about dividends.) As good as it may feel for the owner to walk away with money from his efforts, this withdrawal of capital doesn’t do anything productive for the business. There are fewer resources in the operation. But if you are depending on the business for buying groceries, you’ll have to make a draw.
Using profit to reduce liabilities (debt) is another option. At the point a term loan is paid off, or a line of credit is paid down, future cash flow will increase because payments cease or the interest due is reduced. Is this the best use of a profit dollar? Without getting in to a complex discussion of comparing the likely future return on investment (ROI) vs. the interest rate on the debt, we can generalize. High interest debt should be retired as soon as is comfortable considering the other needs of the business. It’s an instinctive reaction of business owners that they want to be debt free. But this can be short-sighted. A business needs capital to operate and debt capital is generally less expensive than equity. If that sounds surprising, think about it this way. If you have a choice between borrowing money at nominal interest rates versus bringing in a partner and giving away, potentially, a hefty chunk of next quarter or next year’s profit, which would you choose?
The various categories of assets represent the multitude of ways you can invest back into your own enterprise. For example, increasing your inventory, buying new equipment or furniture, or making improvements to your physical facilities are all investments that you hope will lead to making more profit in the future. Interestingly, doing nothing is kind of a way of investing in your business too because not spending your profit means you still have the cash (and Cash is an asset account). Cash in the bank doesn’t, in itself, lead to future profits. But it does provide something very valuable, liquidity, and the options to redirect the money to all of the other options we have discussed.
— Frederick Welk
CEDF Business Advisor