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The purpose of this session will be to provide you with some different options on how to invest your retained earnings and how to evaluate these alternatives. View our list of potential sources of financing for purchasing businesses.
Retained earnings are the cumulative result of a firm's operation from the start-up through the current operating statement. It is the earnings which have stayed in the business rather being taken out. If the business has lost money, it's called retained losses. Retained earnings and losses are cumulative from year to year with losses offsetting earnings.
A growing business will need capital to undertake expansion plans. Expansion capital can come from either retained earnings or from borrowing or a combination of both. Keep in mind that "retained earnings" means that adequate amounts are being spent on maintenance, repairs, research and taxes. Your retained earnings is the cash remaining after all these expenditures.
Some business can build up retained earnings more readily than others. A business requiring frequent replacement of expensive machinery will probably have less remaining cash left as retained earnings than a service business that operates with little or no machinery or equipment.
Throughout this session we will use "Nifty Nail Salons" as our operating business example. Nifty Nails consists of ten operating stores with total annual sales of $2,000,000. Their beginning retained earnings (from previous periods) is $3,000,000.
Retained earnings will be the cash at the end of the year after provisions for all expenses including some accounting effects, depreciation and taxes. Retained losses and earnings are netted out and carried forward from year to year.
In most cases, a growing company will manage retained earnings by investing back into the business or by buying other businesses. In either case, there is a two-step standard test you can use to objectively evaluate the prospects of a business.
Businesses with a competitive advantage as a rule are in unique products or services where the advantage lies with the product rather than the people running the business. Examples include Hershey's Chocolate and Coca-Cola. For smaller growing firms, the goal could be to grow into products or services which could be built into important brand names.
Not all businesses, even widely admired ones, possess a durable competitive advantage. Here are two examples:
So your business plan for managing retained earnings could be to grow your business by investing in situations that possess durable competitive advantages and are attractively priced. Products or services with wide moats around them are the ones that will deliver the greatest results. Here are some business characteristics to look for when investing retained earnings:
During periods of financial uncertainty such as the global economic collapse of 2008, corporations experience uncertainty and fear. As a result, retained earnings were allowed to build up until the expression "hoarding cash" became appropriate. In July of 2010 companies in the Russell 3000 index had hoarded $2.9 trillions of cash. In many cases cash is hoarded in order to provide funds for potential acquisition opportunities.
Distribute to shareholders
Reinvest the cash
The measurable value of holding cash is the earnings received from investments less the annual cost of living increases. The value of having cash to exploit opportunities or acquisitions is hard to measure.
Invest in the business to keep pace
Expand your business
While reinvesting in the business will most likely be your first consideration, calculations should be made to be sure that each dollar invested will increase the value of the company by at least one dollar and that a satisfactory return on investment is accomplished. Let's use Nifty Nails decision to open another salon to determine both the potential market value created and also the return on investment:
Return on equity will vary from industry to industry. Consult with your CPA to determine the ROI history you business and industry has experienced. If you have a higher ROI than your competitors, it is an indication of effective management.
In the early phases of the Nifty Nails Company, owning its store's real estate was not an option because all available cash was being invested in equipment and fixtures for new leased stores.
But let's assume that over time Nifty Nails has grown to 200 stores. Now it is a large creditworthy business and can borrow money at 6% interest. Typically, shopping center landlords expect to receive a 12% return on their properties. Owning real estate rather than leasing becomes a desirable option. All major chains own the land and buildings where stores are located.
Deciding on a business | The business plan | Home based businesses | Financing the business | Business organization | Licenses and permits | Business insurance | Communication tools | Buying a business or franchise | Location and leasing | Accounting and cash flow | E-Commerce | Opening and marketing | Managing employees | Expanding and handling problems
Getting financial controls in place | Getting your team in place | Customer feedback | Achieving lowest expenses | Develop negotiating skills | Alternatives for capital allocation | E-commerce | Growth by duplication | Vertical integration | Franchising your business | Global expansion | Buying businesses | Public ownership | Selling your business | Considerations for family succession
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