Many small business owners strip out the cash out of the business without ever determining if the money is collection of your receivables or actual profit of the business. Many years ago, I saw one business where sales were paid in monthly instalments over a twelve month period. He discounted the cash flow through a third party discount service, then stripped the money out of the business and bought a large house and many assets. The problem was that the business needed the cash to pay for labour to fulfil the rest of the contract. As long as the business had more sales to cover the future labour costs, the owner did not care. In effect this was a Ponzi scheme. After several years, the quantity of new customers decreased and the costs were greater than the cash flow of the company. Eventually, the business went bankrupt.
Business owners can be tempted to pull out the profits of the business however there is always a need to reinvest in the business. Some years, the reinvestment may be small, other years large. It is like a building, if you do no maintenance on the building for years, eventually, you will have a very significant investment required to replace instead of repair things overlooked. In a business, you need to reinvest in infrastructure, people and premises. As business grows you need to add staff. You are more profitable if the existing staff can do the extra work but if you have too much work piled on to too few people eventually staff will start to leave.
If you have a reserve, when times are tough you may not have to lay off staff or you can still give them a small pay increase. If they get no increase, will they leave? By continuing to reinvest in the business, your staff are happy, your clients are happy and you have no money. All these pay back in the long term, short term, the business owner does not have surplus cash to remove from the business but in the long term, the business is healthier, the business is larger and the rewards will be far greater than if the business remained small.
How much should be reinvested – that is the million dollar question. Each company is different. I saw a baker many years ago and his business used ovens and blenders. The handles were falling off the ovens, long extension cords ran over the factory floor because they did not fix the electrical problems. Is this a safe or friendly work environment? I think if the public ever saw the factory, they would not have purchased food from the business. The owner did not have the capital to reinvest in the business and over a 15 year period under his stewardship, the business fell into disarray, the profits were marginal, revenue did not grow and the business had no ability to grow because of old equipment which continually was broken and was fixed temporarily. The short term gain of not investing in equipment resulted in a company with sales which were declining, costs increasing and eventually, the business was put up for sale. The first thing that the new owner did was replace all the equipment and modernize the factory. That was the first step needed to take the businesss to a new level.
The amount to reinvest in each business is different, only you as the business owner can determine what is the optimal amount to spend.