If you run a business and make a profit, you need to be making smart decisions. These smart decisions lead to the most effective way to use your profits. This blog outlines the key factors to consider.
It has been traditional for UK companies to use December as the year-end. The second most popular date is March.
The company financial year-end period is a busy time for many businesses. Big decisions need to be made about company profits and how to deploy them. Accountants may be good at presenting the numbers but you as the owner need to be expert at how profits are used. Nobody knows or cares about your business as much as you do.
Year-end accounts and profits
As a legal requirement for every registered company, year-end accounts serve various purposes. On the one hand, statutory accounts serve as an official record of financial activity and are used by HMRC to calculate corporation tax. But there are many other stakeholders who take an interest in viewing the performance narrative contained within your company’s accounts. What do you want them to see?
Year-end accounts serve one important purpose above all others. They reveal the net profits (or losses) made in the previous 12 months, and therefore inform your key financial decisions.
In the first place, decisions need to be made about how net profit is calculated on the final income statement. Every reduction in profit with a legitimate business expense is a reduction in corporation tax, so lower profits can sometimes mean a healthier final financial position. Is that what you want?
But you and your directors have to keep in mind how your final statement of profit and loss looks to other stakeholders and interested parties. If you have half an eye on a sale, for example, you will want your records to tell a story of success and robust performance. These thoughts may lead you to prioritise maximising profits.
Once the net profit has been calculated, you face the question of what to do with it. If you have an eye on your exit, do your directors or other shareholders know?
Profit distributions and the law
The relevant piece of legislation regarding the distribution of net profits is the Companies Act 2006. It sets out a legal definition of distribution as any transaction which involves the transfer of a company’s assets to its members, i.e. owners and shareholders. The most common form of distribution is the payment of cash dividends. But it can take the form of a distribution in kind, involving the transfer of assets such as property or investments.
Distributions can only be made from your company’s realised profits. The most obvious example of a realised profit is the money made on a completed transaction after costs. In other words, the cash in your company bank account. The key principle is to ensure that distribution decisions are based on liquid assets. This is to prevent unrealised profits being taken into account and also to avoid paying dividends based on forecasts rather than the actual financial position at the time of reporting.
You and your directors have a legal obligation to ensure all distributions are lawful. Two additional principles are that distributions cannot come from capital reserves (i.e. you can only pay out from year-end profits) and that the distribution must ensure the company remains solvent.
High or low profits – what’s best for you?
The first set of decisions you have to make in relation to how you account for net profit is whether you want it to show it as high or low. There are two options that pull in opposite directions. On the one hand, you may want to minimise your corporation tax, which means making the most of business expenses to reduce your net profit. Paying less tax sounds like a great idea. Accountants love it. On the other hand, businesses exist to make a profit. There are reasons to maximise your net income regardless of the impact on corporation tax.
For one, reducing your net profits usually means reducing your liquidity. Additional business expenses to reduce net income are often in the form of fixed asset purchases – investing in new IT equipment, buying a company car etc. Is that right for you?
There are benefits to investing surplus cash into the business but care should be taken so that it does not impact your overall cash flow.
What’s the point of it all?
There are reasons why you would want a healthy net profit to shout about at year end. Your statutory accounts are not just a legal record for Companies House and HMRC. They paint a picture of how the business is performing which many different stakeholders are interested in.
Are you planning any major capital investment in the coming years? A healthy net profit can work favourably with banks and credit rating agencies, or with potential investors.
Strong profits send out a message to competitors that you are to be taken seriously in the market; it also creates a positive impression for suppliers and customers who want to know how stable your finances are before they do business with you.
A good net profit can be vital to securing a place on preferred suppliers lists when tendering for contracts. If you are starting to plan your exit strategy, high profits over a number of years can help to attract potential buyers or enhance the valuation of your business. Being profitable can be a good PR tool, creating a positive story to tell partners, employees, customers and, of course, shareholders.
Finally, looking at tax from another angle, you may find your liabilities are reduced if you take a dividend from profits rather than if you pay yourself a salary. Income Tax hits at 40% on all earnings over £46,351 and 45% on earnings over £150,000. Corporation Tax, on the other hand, remains at 19% up to £300,000 net profit. Directors can choose to remunerate themselves via profit distribution to minimise Income Tax, in which case it makes sense to maximise profits and make the dividends as high as possible.
As the business owner you have the power to decide if and how to distribute any net profits on an annual income statement. One common form of distribution already mentioned is that of directors and/or owners paying themselves dividends in place of a salary. This covers things like performance-related bonuses.
Directors of smaller companies are often shareholders. In larger companies, and PLCs, a key decision will be the size of the dividend to pay out to all shareholders. Although there is no automatic legal requirement to distribute profits to shareholders, many companies have this written in as a condition of the share issue. PLCs are subject to additional rules which mean they cannot issue dividends if their net assets are less than the total of their share capital and undistributed reserves, including unrealised losses.
There are numerous other options available to you aside from distributing profits in the form of cash dividends to yourself and other shareholders. Another option which can be used to reduce Corporation Tax is to put profits into employer pension schemes, either company-run Small Self-Administered Schemes (SSAS) or Self-Invested Personal Pensions (SIPP).
Having a fully-funded pension pot is a great option to have alongside a run-up to a future sale. Funding the pensions of key employees will be appreciated by motivated staff.
Finally, directors have the option to use profits for the benefit of the business itself, as opposed to paying it out to stakeholders. This could take the form of direct investment through purchasing new equipment, upgrading premises, or specific projects, such as new product development or a marketing campaign.
Profits are also used to pay off debts and loans, which helps the broader financial picture in two ways: reducing overall liabilities and lowering expenditure on interest. A third option is to retain net profits in the company reserves to assist with future liquidity and cash flow.
The handling of net profits in year-end accounts leaves you with a number of important business decisions to make. The impulse to reduce tax by lowering net profit is offset by the desire to paint performance in as favourable a light as possible for current stakeholders, lenders, potential customers and suppliers, investors, or perhaps even buyers.
Profits are distributed in one of two ways, via cash dividends or other asset transfers to shareholders, or by being redirected into the business. There are clear regulations for how payments must be allocated from realised profits only. This ensures that companies live within their means when it comes to remunerating owners and shareholders.
Your smart decisions will be directed by current circumstances and future prospects. Whether you are set for a 10-year growth spurt, are keen to buy competitor businesses, or are within three years of an exit, your profit extraction decisions will be different.
If you value an impartial yet informed second opinion, please call us. The team at Capital have been helping entrepreneurs plan their future for decades. Contact Capital today to get your business year off to a great start.