And perhaps even more important, “where” are retained earnings?
Retained earnings is a term that most every small business owner has heard. And while not every interior designer sees a balance sheet every month, they could probably tell you that “retained earnings” is a line item on the balance sheet.
The reason few business owners pay much attention to their balance sheet can be summed up by the retained earnings line item because all they know is that it has nothing to with cash! And while it may sound great in theory (“Hey, you mean I’ve retained some earnings?”) it has no impact on the only two measures that really matter—cash in banks and projected cash flow.
Blame Accrual Accounting, Again!
You’ve no doubt heard this term, and even though there’s no real reason to do so, about 95% of your CPAs have set up your books on an accrual accounting basis. Why? Not because it’s easiest for you, but because it’s easiest for them! (The alternative, if you’re wondering, would be to set your books up on a cash basis, but that’s for another time and place.)
Under accrual accounting, the bottom line on your P&L statement, be it positive or negative, is not a cash number. It’s profit or loss as defined by the rules of accounting, not the rules of what’s actually in your bank account.
Since the P&L statement is zeroed out every month (when the books are “closed”) the accumulated profit or loss must be stored somewhere else. So, it’s moved over to your balance sheet and either adds to (if positive) or subtracts from (if negative) the line item called “retained earnings.”
That’s why I often hear the question when a designer looks at his or her balance sheet and sees a number in retained earnings, say, $214,098…but has only $15,000 in the bank and wonders, “Where is that money?” Well…it’s nowhere because it never really was “money,” it was only “earnings,” another made up word in the world of accrural accounting.
So, Should You Actually Retain Some Cash?
Absolutely you should retain some cash because certain expenses (taxes come to mind!) have to be paid in cash, not in “earnings.” The IRS will not see the humor if you say, “Let me pay you in ‘earnings’ this year instead of cash!”
You may also need cash to reinvest in your business, perhaps to purchase new furniture and equipment. You might even want to save up so that you can pay cash for a marketing campaign rather than putting it on a credit card.
In my business, and even in my spreadsheet projection of the next 12-18 months, I always subtract 20% of revenue as a provision for taxes. I literally sweep 20% of all revenue into a savings account that will help me to offset, if not completely cover, income taxes when due. I tend to try and save an additional 10% of all revenue for what we might call, “retained cash flow.” This can allow me to pay cash for new equipment, travel, marketing, IT, etc., rather than putting it on my line of credit.
Cash is King (And you can quote me on that!)
I have a way of coining new phrases, and I’m really proud that I came up with this one, “Cash is King!” It really is and while I encourage principals to have lines of credit or credit cards in place for emergency, everyone should also project cash flow out for as far as possible and make sure that you retain enough cash to grow not just on a piece of paper called your balance sheet, but in your bank account!
A Free Course in Finance for Edge Members
There is a terrific course available to Edge Members at no charge called “Financial Statement Basics.” Every member of The Edge should take this course! You can find it at www.interiordesignmba.com, and your coupon code is available on your login page at www.designingprofits.com.