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Financial Adviser: Should I reinvest excess cash into the business?

Don't make the mistake of investing excess cash indiscriminately.
By Henry Ong |

Q: The startup business I launched 18 months ago has been doing well. It has generated good profits despite the heavy competition in the market. As the business grows, should I reinvest excess cash from profits into the business? Or should I just declare dividends and take home the profits?  – Krizzha, by email

 

 

A: It is nice to see your startup surviving and making money despite the challenging economic environment. But before you start thinking of where to invest your profits, you have to establish how much working capital you really need to operate the business. How soon are your profits translated into cash? Does your business rely on giving credit to clients to grow your sales? How much of your accounts receivables are collected on time?

 

There are many businesses that may seem so successful from the outside but when you look into their cash flows, they are financially struggling. Many of these started as successful ventures until mismanagement affected their finances.

 

 

First, determine how much cash you can take out from the business.

If your business is already enjoying a cash hoard, you can invest only the portion that is free from budget. Many entrepreneurs make the mistake of investing their cash indiscriminately, not realizing that they are already using their working capital for other purposes.

 

When this happens, the business starts to have problem with cash flows. To determine how much cash you can take out from the business, make sure that current liquid assets such as cash and accounts receivables are able to pay all your liabilities.

 

For example, your total cash and receivables amount to P500,000 ($10,794.66 ) and your total payables, including bank debts, is P300,000 ($6,476.80), then your free cash is P200,000 ($4,317.99). From this amount, you can establish your limit on how much you want to play with.

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Option 1: Reinvest the cash in the business to boost sales.

When you have the cash ready for investment, you have three options. One is to reinvest your cash into the business to grow your sales. You can do this by providing more capital to finance your accounts receivables or inventory. The more credit line you make available to your clients, the more sales you can generate.

 

Of course, when you do this, you also increase the risk of bad debts and you may never recover it anymore. Situations like this can happen especially if your industry is very competitive and margins are not stable. In order to limit your risk, develop your business advantage, and implement strict credit control policy. In this way, you grow your business and strengthen your market position.

 

 

Option 2: Invest the cash in other businesses.

Do not put all your eggs in one basket as the saying goes. If you have excess cash, you can consider diversifying into other businesses. Invest in businesses that will not be easily affected by slowdown in your industry. For example, you can invest in businesses that are not directly affected by seasonality of your current business.

 

You can grow your businesses and build your own portfolio of investments similar to what the big boys are doing. However, this may be easier said than done. Going into unfamiliar business may be more difficult for you because you may not have the competence and the same passion as you have in your current business.

 

In fact, this may be more risky. To manage this, spend time to study every business opportunity until you are comfortable. If you need to get partners to help you, get somebody you trust who is competent and experienced in the business.

 

When you invest, make sure that the projected return of investment of the new business is acceptable. How do you know that it is right for you? Determine your current return on investment from your business. Compute this by dividing your net income last year and your investment equity. You can ask your accountant to help you with this by getting the figures from your financial statements.

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For example, if your return on investment is 20% per annum, then your benchmark for accepting new businesses must earn at least higher than 20%. Why higher? It is because you need to add some premium to cover your risk by venturing into a different business. So you can demand, for example, 30% target return. You can turn down proposals that offer lower than this.

 

 

Option 3: Take out the excess cash as dividends.

If there are no available opportunities for your business to invest, you can simply take out the free cash as dividends. Keeping your cash in the business without any productive use actually destroys your business value. Using the same example, if you keep on accumulating cash, your equity will also increase. If you earn the same net income with larger equity base, your return on investment actually drops. The more money you keep in the business, the lower your return on investments, which is not good.

 

When you declare cash dividends, the excess cash from the business will become part of your personal wealth. You can invest this money into bonds, stocks, or real estate. Create your personal investment portfolio and allocate your money among these investment vehicles.

 

If you are not familiar to managing personal wealth, you can consider hiring someone who is competent in this area, or a Registered Financial Planner (RFP) to help you out.  It is not how much money you make from the business that matters, it is how much you keep and invest for your financial future.    

 

*****

Henry Ong, CMC, is president of Business Sense Financial Advisors. You can follow him at @henryong888 or email hong[at]businesssense.com.ph.

 

Photos from Shutterstock

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