For a small business owner, knowing if and when to invest your profits involves a balancing act. On the one hand, you want to put those surplus funds to good use — either by reinvesting in the business itself, or by extracting the capital to invest elsewhere so you can personally benefit from it. Yet at the same time, you do not want to deprive your business of funds and hinder its ability to operate.
Managing this balancing act is an extremely valuable skill for any small business owner. It involves analysing your business finances, recognising when it is appropriate to invest, and doing so in the right way. With this in mind, here are the essential steps to follow.
Identifying whether your business is ‘in profit’
As your business starts to get established and you’ve purchased your startup essentials, you should reach a point where the revenue coming in appears to be greater than the amounts you’re having to spend. So does this automatically mean that you are in profit?
Even if your bank account balance is in the black, this does not necessarily mean the same as being ‘in profit’. To get the true picture, you need to be able to accurately assess the income and expenditure you have incurred. Only in this way can you really tell whether your business is in profit (where income has exceeded expenses), or in loss (where expenses currently exceed income).
This is why it is so important for a business to have a profit and loss (P&L) account. In this relatively simple document, you list all of your income or turnover for any given period at the top, followed by all expenses and costs. The bottom line figure is the difference between the two.
Legally, you are required to produce a P&L account at least once a year to comply with tax legislation, and, if your business is a limited company, to file company accounts. But this shouldn’t be regarded simply as an ‘admin requirement’: your P&L account is a useful tool for assessing the financial health of your business. As such, for your own benefit, it can be worthwhile to prepare a fresh P&L on a quarterly basis, to track your progress — and to assess whether your business really is ‘in profit’.
Will your business have enough funds in the future?
If you were to empty out your business of its profits, and tie up that cash in investments elsewhere, it would be difficult and inefficient, from a tax planning point of view, to reverse the transaction. So once you have established that your business is in profit, an important next step involves making sure your business is going to be covered for its future commitments.
For investment planning purposes, a ‘business budget’ provides a very useful accompaniment to your P&L account. If the P&L tells you whether you are in profit right now, your business budget tells you if you are going to be in profit in the future — and by how much. Once again, this need not be a complicated document. As with the P&L, it typically consists of sections for expenses and income, but this tool focuses on the future (the next six months, for instance). For each item, you should estimate the amount your business will receive or incur in one column, while in a further column, you enter the actual amount received or incurred — and the difference between the two.
This should be a ‘living document’, updated on a regular basis. It enables you to assess upcoming expenses and income, helping you predict if, and by how much, you have a surplus to invest.
Should you extract or re-invest? Refer to your business plan
Let’s say, looking at your P&L and your business budget, your assessment leads you to conclude that you could potentially withdraw up to £5,000 from your business, without leaving it at risk of cash flow problems. So should you do it?
Before deciding, you should look beyond your day-to-day business commitments, and refer to your medium and long-term plans for your business. This is one of the reasons why a business plan is so useful: a detailed description of what you plan to achieve, how, and when.
As an example, your business plan might include plans to launch a delivery service in the next financial year. If you’ll need to invest in a new vehicle in the near future, how does this affect your decision? It might be, for instance, that using the £5,000 surplus as a down payment could mean a better financing deal. This is why investment decisions should always be made in the context of business planning decisions.
The value of financial advice before investment
Analysing your business finances lets you see whether it is possible and prudent to remove money from the business for investment purposes. Next, you need to decide how to do it — and where to invest. Much of this depends on your personal goals and wider circumstances, which is why you should always seek independent financial advice before making big decisions.
The approach outlined above hopefully illustrates how useful simple accounting and budgeting tools can be in helping you to make better decisions about your business, and its ability to invest. For more tips on preparing accounts, budgeting, and investing, head over to our help centre. For advice on banking, we have a specially created company formation guide which will help you from start to finish.