Question: My online fashion business has been doing very well since we started last year. My business has accumulated quite substantial cash reserve to date. I do not really need the money to expand the business at this point, as capacity can easily meets demand. Should I keep my money in the business? – Hershey by email
Answer: It is always nice to end the year with record sales and profits, and having excess cash as a result is a good problem to have.
Having additional working capital will keep you liquid. If you do not plan to expand in the near term, consider keeping some of the excess cash as additional working capital. Use it to pay for salaries and other expenses like payments to suppliers. With extra cash, you would not need to secure loans with high interests just to pay your suppliers on time.
There is no hard-and-fast rule as to how much in standby funds you will need, as the amount varies for different industries, but consider an amount equivalent to three months of your operating expenses. If you have more and you want to keep the cash for emergency purposes, opt for short-term investments with decent returns.
Over time, when your business continues to do well, you might end up with a huge amount of working capital that you do not use in the business. One way to control this is by monitoring your return on equity (ROE) ratio. ROE is computed by dividing net income by the capital you invested in the business.
How to compute for ROE
Assume your net income this year is P500,000 ($10,779.35). Divide that by your capital or equity of P1 million ($21,558.69), you will have ROE of 50%. The following year, you decided to keep the income in the business so that your beginning equity is P1.5 million ($32,337.69).
Let us say your net income rose 25% to P625,000 ($13,479.06), if you divide this by equity of P1.5 million ($32,342.54), ROE will fall to 42%.
If your income increases every year and you accumulate excess profits in the company, your ROE may steadily fall as your equity expands. Falling ROE may eventually lead to value destruction due to lost opportunities that the extra cash can generate.
If you find business opportunities where you can invest the extra cash that could generate a return of 30% per year and your ROE in the business happens to fall to 20%, your value destruction would be 10%.
How to keep your ROE
It is possible that you keep your ROE at 50% every year while your net income continues to grow. How do you do this? When you have more equity in the business, you have bigger capacity to generate business. It is assumed that you will use the excess money to expand and boost sales and income.
The challenge in having bigger equity base is how to maximize excess cash to generate more profits for your company. There is an added responsibility in ensuring that the expansion resulting from utilizing the extra cash must add value to the business.
There are accompanying risks in every business decision. You might over expand your current business, which may hurt your ability to price your products profitably or you may venture into other lines of business that may prove to be too risky.
If you feel you are not ready to expand and want to keep the business financially fit, you need to trim excess fat by taking out cash from the company by way of dividends. When you get dividends, you avoid accumulating any excess that increases your equity. In this way, you can focus on achieving your target ROE every year.
Any cash dividends that you get from the business are no longer part of the company, but your personal money. If your business needs extra cash for expansion in the future, you can always reinvest.
Henry Ong, CMC, is president of Business Sense Financial Advisors. Email Henry for business advise, hong[at]businesssense.com.ph or follow him on Twitter, @henryong888.
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