Reinvesting your retained profits into the business is clearly the optimum form of finance.
If your enterprise is making profits, it can reinvest them to further improve profitability, productivity or efficiency and will improve balance sheet strength. This will increase the value of the business without the commitment of liabilities.
Retained profit formula
Before forming an investment strategy that relies too heavily on reinvestment, recheck and discount the basis upon which you make profit forecasts. If this is a new enterprise, what is the confidence level of the projections?
Very few enterprises make profits in the first 2 or 3 years of trading. This time is usually spent learning the trade and finding the market. In fact, many enterprises fail just as they prove that they have a product, a market and potential for profit-making, simply because they lack working capital.
More mature enterprises can look back on their own record of actual profit against predicted profit and base their estimations on the emerging pattern. Starting with an uphill struggle through break-even point (the point in time or number of units sold at which the business becomes financial viable and the revenue equals the total costs) over 3 or 4 years, the pattern then move on to modest but gradually improving profits.
Retained profit advantages and disadvantages
You will need to decide what level of profits to reinvest as you generate them. Sharing profits is one of the ways enterprises justify their existence and retain the loyalty of members. If you reinvest 100% forever, there will be no financial reward for good performance.
Financing any business solely from retained profits is a prudent way of running a business. However, it can make seizing some opportunities impossible, forcing you to pass up the chance to increase profitability and financial or social returns.
For example, investment in machinery that will enable twice as much production for the same level of labour may mean it will pay for itself in a year. This will in turn lead to an increased turnover which will boost profits. If the retained profits are insufficient, it would not be possible to take advantage of this excellent opportunity without using other forms of financing.