Reinvesting? Plowing back earnings? Come on. Is that really what's happening?
It is a common notion that you have to reinvest your earnings to grow, and there is definitely some logic in that.
But here is the problem. Saying that you would have had a profit, but you reinvested your earnings is a pretty great justification to help us feel better about a business that just isn't doing what we had intended it to do. And it is a lie that we can really believe because we actually have spent those earnings on the business. But there is a very big difference in spending and investing. Dumping money into ads that aren't producing isn't investing. Neither is spending on pumping out new products and services out of pure hope. If you don't know exactly where your profits were reinvested, you didn't really reinvest them at all.
Here is what true profit reinvestment should look like. It is a planned, strategic process that can be measured and managed.
First, you save. Every business should have enough cash saved up to cover three to six months worth of operating expenses in case of a rainy day. Don't reinvest until you have saved enough cash to cover at least three months of operating expenses. Keep a practice of setting aside a set percentage of each sales deposit in a separate account for your rainy day fund. This will force you to find a profitable means of operating. For example, if you set aside 10% of every incoming dollar and operate your business consistently off of the remaining 90%, you know that you have found an operating model that generates at least a 10% profit. Separating the cash out is key.
Once you have reached that first step of establishing a sufficient rainy day fund, you can actually start the process of reinvesting. Reinvesting can mean a lot of different things. Maybe you have identified a repeatable marketing processes that just needs cash poured on to to generate more profit. Maybe reinvesting means bringing on a new hire, or purchasing a new piece of equipment. But whatever reinvesting means to you, it needs to be done in a managed and measured process. A budget should be set and followed, and results should be measured to ensure that the reinvestment is actually generating the benefit that you intended. Otherwise, you risk throwing good money after bad.
Again, separating the cash out for purpose can help. Let's say that you are planning on reinvesting a portion of your profits into a new marketing strategy. Rather than just spending and crossing your fingers, you should first set that cash aside out of your retained earnings. Make sure that you are leaving enough that you still have at least three months of rainy day funding set aside. Choose an amount to earmark towards the new marketing strategy that will be sufficient to test the strategy, and don't spend beyond that amount. This creates discipline in how much cash you are risking. Evaluate the results before you begin earmarking another chunk of cash to the this purpose, and always be sure to never pull out of the rainy day fund.
Another reinvestment scenario might be the purchase of new equipment. This scenario can play out in a couple different ways. If the equipment can be purchased at a price that can be saved up for in a reasonable amount of time, do that. Once you have your rainy day account funded, start setting aside cash for the purchase of the equipment until you have enough to make the purchase. This is the ideal option, but in reality, sometimes we have to take on some risk to grow.
Sometimes the cost of equipment is too high to reasonably be saved up for, and we need to take out a loan or lease the equipment instead. In this situation, we need to modify our approach a little. The first step is still to make sure that our rainy day fund is adequately funded, but keep in mind that adding a loan or lease payment is going to increase our monthly operating costs. This needs to be accounted for in the rainy day fund. So if the payment is $1,000 per month, at least another $3,000 should be added to the rainy day fund to cover the minimum three month savings goal.
Next, you will want to test to be sure that you can absorb the added $1,000 per month payment in your operating budget. To do this, you can set up a savings account and transfer that amount of cash to the account each month to simulate making the payment. You may want to transfer a little extra, 10-20%, as contingency to be sure that the payment can be covered in slower months. You always want to keep seasonality of sales in mind.
After running your test, you might find out that you can't actually make the payment. You might want to justify making the purchase decision anyway by telling yourself that you will be able to sell more once you have the new equipment. This is a dangerous line of thought. Being able to produce more doesn't necessarily mean that you can sell more. If you are turning down a significant amount of sales because you don't have the capacity to meet the demand, then you might be justified, but a lot of the time, we are just trying to convince ourselves of something that necessarily isn't the case. And even if it is true that you are turning down sales due to restricted capacity, there are probably still better options for you than just making the purchase and crossing your fingers.
First, if there truly is such a high demand that you can't fulfill it, this may indicate an opportunity to raise your prices. It's basic economics. If there is more demand than there is supply, raise prices until demand equals supply. If you can raise your prices, you can increase your revenue without having to increase output. After this you may then be able to purchase the new equipment or find that you don't even have to purchase it at all.
If you find yourself in a place where you can't make the monthly payment, and you aren't in a position where demand justifies increasing prices, then you need to start looking at what else you are spending on. You can probably find areas to reduce costs. I would argue that this is a great position to be in because you are forcing yourself to find efficiencies. You might find that you are paying for small software subscriptions that you aren't actually utilizing. Maybe you have been paying for ineffective marketing like boosting Facebook posts that aren't actually generating a return. Go back to all of your vendors and see what you can negotiate. It never hurts to ask for a discount. Reevaluate your suppliers. Don't be afraid to go out and see if you can source your supplies at a lower cost. Take another look at your processes. Can you operate more efficiently to become more profitable?
In the end, if you take all of these actions and you still can't make the purchase, that simply means that you shouldn't. The important takeaway is that you are making the decision from a position of discipline.