There’s an old business adage that states “revenue is vanity, cash flow is sanity, but cash is king.” Unfortunately, for many mid-sized business owners, it’s the latter part of that saying that seems to resonate especially well. And as a result, the landscape is littered with once highly successful small and mid-sized enterprises that suddenly find themselves struggling to stay afloat.
As their businesses finally turn the corner and become profitable, many entrepreneurs who have personally sacrificed for years to build their companies have a natural and understandable desire to begin enjoying the fruits of their hard labor. In fact, it’s not at all uncommon for owners to be extracting nearly 100% of net income out of the company. What they fail to consider, however, is that by taking all the money out of their business they are de facto leaving it highly levered and assuming significant undue business risk in the process.
It’s an immutable business truth that managing cash flow is vital both to the survival of your business as well as to its long-term viability and growth potential. But the challenge that many owners of mid-sized firms struggle with is finding the optimal mix of how much cash they can safely extract from the firm, and how much should be retained in order to fund the continued growth and expansion of the assets in the business.
Striving for stability and sustainability
There’s no shortage of examples out there of mid-sized firms that have grown from $30 million to $100 million over a long period of time without ever assuming excessive risk or becoming highly leveraged. Instead, these companies are typically captained by CEOs who are committed to steady, sustainable annual incremental growth goals, and who have successfully stayed the course.
Those firms represent a small and distinct minority. Often, in sitting down and consulting with clients we encounter ballooning balance sheet debt and rising business risk that’s directly attributable to the owner(s) taking too much equity out of the business.
As a case in point, let’s look at a hypothetical export and trading company that’s generating a steady $15MM in annual sales and, because of that industry’s relatively thin margins, is throwing off about $500K in net income each year. Rather than retaining some cash in the business, the owner has been extracting the entire $500K (with $200K of that earmarked for taxes and $300K taken as a withdrawal). Assuming that the company’s inventory and receivables are approximately $2MM and the owner can finance half of that, the owner will need to maintain $1MM in equity.
But here’s where the difficulty arises. Consider what happens if that $2MM in inventory and receivables increases by a mere 10%. Since he can only finance half of that increase ($100K), suddenly the owner may struggle to find a source of funds for the other $100K. With no retained income left in the business, that money will ultimately need to come directly out of the owner’s pocket.
Finding the right balance for your business
To rectify this problem and ensure that the business retains sufficient cash to fund continued growth and expansion, the owner must understand that he or she can only take a percentage of the net income, and to determine based on the individual owner’s needs and the anticipated needs of the business exactly what that allocation should look like. If future business growth is a secondary consideration to personal income needs, then perhaps a much smaller percentage of net income will be retained.
In the case of our trading and export company example, however, the owner has aggressive plans for continued expansion into new markets. In light of that, an optimal solution for this business would likely necessitate that a sizable allocation of cash generated(perhaps as much as 40%) be retained in the business.
Determining what is right for you and your company will be driven by a host of factors unique to you and your business, not the least of which are the tax considerations and implications associated with various strategies. There’s no one-size-fits-all solution. But if future growth is even a remote consideration, now is the time to begin exploring ways that you can begin retaining equity in your business to fund tomorrow’s growth.