The first is by paying yourself a salary because you work in your business. As the General Manager, the MD or the CEO, your salary is a valid business expense.
The second way is by paying out profits to yourself that have been earned by your business. Profits withdrawn from your business are referred to as drawings when withdrawn from an unincorporated business such as a sole trader (and referred to as dividends if the profits are paid out from a company).
The important point here is that money taken out of a business as drawings or as dividends are not a business expense; they are the return of profits from the capital invested in the business to the owner. To pay out profits, a business must have not only the cash available in the business bank account; it must also have the profits.
Taking profits out of a business, however, means that those profits are no longer available to reinvest in the business. Lenders get concerned if they see profits been taken out for personal use and, at the same time, the business asking for more money from the lender!
If, on the other hand, you decide to reinvest your profits in your business rather than pay them out, a lender sees that a sign of your commitment to your business. Better still, you can take a decision to reinvest profits permanently in your business: this is done by reclassifying business profits as permanent capital. Accountants have a fancy name for this; they call it capitalisation of earnings.
A business that reclassifies its profits as permanent capital is sending a clear message to their lender that they are going to leave existing profits in their business for the long term. This is one way of giving a lender some reassurance that you’re not on the next flight to the Maldives with that loan they have just approved!
Remember, lenders may have genuine concerns on the potential use of borrowed money by a business where they see high levels of profits available for distribution. One way of reassuring your bank that you are committed to your business is to consider reclassifying profits as permanent capital and, by doing so, make those profits no longer available for distribution. You must, of course, take appropriate financial and tax advice before committing any profits in your business as long term capital.
David Sparks worked in business banking for over 20 years and offers practical guidance to businesses on presenting their case for finance in more challenging and turbulent economic times. http://www.financeandbanks.com
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