Improving financial structure
For Michel Babeu, CPA, CA, associate with Richter, the first concern of a business starting to see profits should be to improve its financial structure. "In a start-up business, the working capital ratio is often 1: the short-term assets are of an amount just about equal to that of short-term expenses. When you start to generate profits, it's good to return this ratio to 1.2." This is like having $1.20 of short-term assets (client accounts, stocks, inventory...) for each dollar of short-term debt (notably supplier accounts, salaries and bank loan payments).
One of the avenues for improving the working capital ratio consists of reducing your debt. By using your earnings to repay a loan, for example. The other possibility is to increase the working capital by simply leaving surplus liquidity there.
The big advantage of a higher working capital ratio is that the business can then handle unexpected situations more easily, whether the surprises are good or bad. A machine goes kaput? You can repair it or replace it without too much difficulty. An important contract comes up? You'll be in a position to accept it and finance the growth of the business, with investments in labour, equipment and necessary raw materials.
Having more liquidity has another positive side: "When you're able to pay your suppliers quickly, you're in a situation where you can ask them for a discount. A reduction of 1 or 2% for payment in less than 10 days is a better return than most investments these days", asserts the corporate taxation expert.
Pay bonuses or dividends
Then, entrepreneurs who are looking to secure their personal financial situation or that of their family can pay a bonus or a dividend. But at what point do they have enough money in working capital to allow for this?
To answer this question, we must first consider the requirements of lenders. "The financial institution is a business partner, reaffirms Michel Babeu. Often, the lender specifies that you can't pay bonuses or dividends without its agreement, and requires that a certain working capital ratio is respected before giving its authorization, for example. "
When the financial institution's conditions are met, when the working capital ratio becomes high – Michel Babeu speaks of a ratio of 2 – and when the debt ratio sits at around 60%, the accountant believes that it is a good idea to take out additional assets from the business, in order to decrease the share of risk that it assumes.
So would it be better to pay a bonus (subject to a personal tax on revenue) or a dividend (on which the company and the individual will be taxed)? "In total, the difference in tax burden between the two options is approximately 2%", says Michel Babeu, who considers that the second option is only slightly more advantageous.
Create a holding company
The entrepreneur can also create a holding company that would hold the assets of its company (the "operating company"). The profits of this operating company would be paid to the holding company without being subject to corporate tax. Only the holding company's revenues would be. In addition, the assets that are paid in the holding company are protected from the creditors of the operating company, which reduces the business risk.
"The deferred tax can be invested in the Stock Market, in rental property... You leave them in the holding company to make investments and to make them grow, a bit like an RRSP – unless it's to be used to launch another business", explains Michel Babeu.
This coin, however, has two sides: "At the time of selling the operating company, the risks may be so great that the buyer doesn't want the holding company and the investments that it holds", warns the chartered accountant.
Not to mention that when the business is sold, a holding company holding it in full is not eligible for tax exemption applicable to the first bracket of $825,000 in capital gains. The exemption is in fact reserved for individuals.
To avoid this problem, Michel Babeu offers a mixed option, combining a holding company and personally held assets – within the context of a family trust that possesses the business, for example.
Reinvest in the business?
The portion of profits that should be reinvested in the business to make it grow varies greatly from one area of activity to another, even from one business to another, according to Michel Babeu. "The only common factor is that a healthy business should have a debt ratio which does not exceed 60%. At 75%, the creditors will find that the risk is too high in relation to the interest that they would draw. "
In his opinion, it's not bad for a growing business to have debt: "When a business is 100% in equity, my advice would be to take out a loan, in order to share the risk with the bank.”
The acquisition of a competitor, the purchase of equipment designed to improve productivity, and the expansion of a factory are just a few of the possibilities among the many ways to reinvest the surplus liquidity – decisions that depend on the situation of each business.
