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Keeping your paycheque in check

Thursday, 14 April 2011 | By Greg Hayes
For many business owners one of the drivers for being in business is the financial return. It is the reward for the risk you take and the effort you put in.

 

There are plenty of other reasons that people go into business but for most, financial return is in the top three reasons.

 

As the business generates profits and cash, one of the questions you need to address is how much cash can you reasonably take out of the business.

 

Tax and other issues overlay this and you want to make sure you do it as effectively as possible.

 

Nonetheless the fundamental questions are how much can we take out and how much should we take out?

 

For some business owners the answer is as much as possible. For others they are content to let the business take its time.

 

Irrespective of what your attitude is to this question you should consider it. You should know what your business should be producing and capable of returning to you.

 

Whether you take it or not is another issue, but knowing how much you should be able to take is a key business measure.

 

It’s too easy to mask true business performance, by owners modifying the amount they take out of the business and justifying this on the basis of keeping their tax down.

 

Keeping your tax low is not hard. Don’t make much money and you are there automatically.

 

The key is for your business to make a lot of money and for it to be as tax effective as possible.

 

From a shareholder perspective there are three levels of income you should expect from your company, assuming that you work in the business.

 

Here are the three:


  1. The first is a fair return for your labour. This number has nothing to do with tax efficiency. It is all about how much you should receive for the work that you do. It is a market based return.
  2. The next level of return is on the capital you have invested in your business. You could have put this money into the bank or into an alternate investment. There should be a reasonable return on your capital.
  3. The last level of return is the profit or risk return you should achieve.

It is the premium you should expect for the risk of being in business and your return for the opportunity that you have developed.

 

Having calculated this amount you then need to look at how much cash the business needs. Most businesses, particularly in their early years will need capital for growth.

 

A good starting point is to look at how much capital the business started with. If the business was under capitalised then you will need to retain profits in the business to build up its capital base.

 

As it grows it will typically need cash to fund this growth. The amount of cash required will depend on things like your cost structure, whether you need to carry stock or work in progress and how long it takes for your customers to pay you.

 

It is possible to work out this number for every business.

 

Apart from your growth and working capital you also need to look at how much cash you need to cover costs for taxation, any loan repayments or capital replacements.

 

Beyond this you should have some buffer level of cash that will cover the unexpected. Everything doesn’t always happen as planned.

 

You need to allow for the unexpected. Businesses can get caught out by having no buffer.

 

Bring all of this together into a financial model for your business, and it will tell you not only how much you should be able to take from your business but also the capacity of the business to manage this.

 

After that you decide what you want to do, but you are armed with some great management information.

 

A lot of businesses get themselves into trouble because they have never found out the answer to this question. Don’t be one of them.

 

Greg Hayes is a director of Hayes Knight and specialises in taxation and business planning advice.