What are the 3 main uses of net profit?

What are the 3 main uses of net profit?

How should I spend my net profit? This is a question most business owners grapple with when their business starts to run at a profit.

Now that you have some net profit, what is the best way to spend it? Of course this is a good dilemma to have, but it’s important to think strategically about your next move in order to get the most for your hard-earned money.

 

Firstly, what is net profit? Don’t confuse net profit with cash. Simplistically, net profit is a measure of revenue less expenses – and revenue is not always cash-based. Revenue can be recognised when invoiced to a customer, regardless of whether or not the cash has been received. Expenses also include items like depreciation and amortisation, which are both non-cash items.

 

With that in mind, there are three main ways to spend net profit: invest back into the business, pay off debts or pay out dividends. Let’s take a look at each option in more detail.

 

1. Invest back into the business

During a company’s early years, most of your net profit should be retained within the business to invest in growth. A common mistake some small business owners make is pocketing all of their net profit – treating profit like a salary. While you will need to pay yourself some money, it’s generally advised to keep at least half of the profit within the business to fund its growth potential.

 

Of course how much you can reinvest will depend on what you need to live off and your business’s goals. Many business owners are known to live like paupers in the early stages of business!

 

2. Pay off debts

If you’ve recently started a business, chances are you have some debts. Whether or not you should pay these off immediately will come down to your long-term goals – and how pressing each debt needs to be dealt with. It can feel like a chicken-or-egg situation. Do you continue to reinvest in the business in the hope of earning enough to cover all your debts in the future? Or do you pay them off as you go even if this slows you down? There is no golden rule: the answer will completely depend on your unique financial situation.

 

It’s important to have a ‘numbers person’ on your governance board or in your team – or work with an experienced financial adviser – so you can make the best decisions for your business.

 

3. Pay out dividends

A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to ts shareholders. Dividends can be issued as cash payments, shares of stock, or other property. In other words, to pay out dividends means to pay your shareholders (and yourself).

 

Although this is the most exciting option, it can take some time to get to this point. In most cases, shareholders expect to wait a period of time before they start seeing a financial return – they understand that growing a business takes time.

 

Now that you understand the three main uses of net profit, you’ll see that they are very dependant on the life cycle of your business.

 

In the early stages, you’ll probably spend more investing back into the business and paying off debt, and as your business matures you’ll start to reap the benefits and pay out dividends.

 

The most important thing is to understand what your company’s goals are, and make decisions based on achieving these milestones – all while managing shareholder expectations and staying on top of debt.