Welcome once again. Today let’s take a brief look at the subject of drawings. By drawings I mean moneys that the owner(s) of the business take from the business basically for private or personal use. It could be hard cash taken from the business, or physical goods in kind taken from the business, or in some cases personal expenses incurred on their behalf. Principally these are personal in nature and do not constitute expenditures for the business. Generally the bigger and more established businesses have in place systems and procedures to manage these, and normally it’s not a very big deal. Small enterprises however do not, and sometimes drawings can turn into messy things.
Different entrepreneurs have their own ways of dealing with drawings. There are also no hard rules of handling or managing drawings, and the principles that I’m going to provide below are guidelines. Of course, they are valuable guidelines that can help entrepreneurs manage their drawings well, and avoid as much as possible the negative impacts of drawings on the business, in addition to avoiding other related problems with tax authorities etc. So, what should an entrepreneur know about drawings? What are some of the tips regarding drawings that are valuable to an entrepreneur? Are there any useful guidelines that can help an entrepreneur manage his drawings from the business? Yes there are. Here below are some.
- Drawings should be made from profits and not working capital. There are entrepreneurs who simply think that any monetary resources in the business bank account are available for personal use of the business owner at any time, and to any amount. Not all moneys available in the business are for drawings. I know this does not sound well with some obstinate and undisciplined entrepreneurs, but it is the reality. Drawings should be made from profits the business has made, and not from the capital of the business. This implies that if the business is a start-up, or an old business that is not making profits, no drawings are advisable. Mr. Entrepreneur, I don’t want to sound very tough but you simply cannot live off an enterprise from day one. You need to give the business time to stabilize. Ok? There is this concept of paying yourself first, among business owners, but this is sometimes carried too far.
- Not every profit made should be withdrawn from the business. Again, you can’t draw out every profit your business generates. Don’t become so hopelessly scientific with numbers in an effort to know what you must take out on a weekly or monthly basis in the name of profits. Part of your business profit should remain to finance investment and create some reserves for the future. It is also good to save and not waste every gain you make. Some natures of businesses such as limited companies are more regulated and hence issues such as drawings are also taken care of. Well established and properly run limited companies normally share dividends once or twice in a year if they make profits. For entities such as partnerships sometimes there is chaos, even to the extent that partners fight about this issue of drawings and profit share. Some smart partnerships however manage their affairs so discretely and you want even sense any form of discord. For sole proprietorships, the individual is his own decision maker, and hence can draw in very irregular ways, without anybody quarrelling. If it’s a husband and wife quarrelling, you simply leave that to them to sort it out in the bedroom. They will agree somewhere, and if they don’t you are not going to be the one to show them different directions. Ok?
- You should know the amount of drawings that your business can afford. It is strongly advisable that as an entrepreneur, you know the limit of drawing that your enterprise can manage without distorting operations. Don’t base your drawings on how much you need to keep going or to meet all family bills. Don’t base it on some imaginary numbers you dream about. Use a logical, accounting and mathematical approach to determine this. I have already warned you at the start that drawings should be made from profits. This means that you will calculate the profit your business makes, and then reserve part of it as mentioned in my point number two above, before taking out the balance. If you know how to calculate this, well and good but if not, kindly consult an accountant or business consultant to do this for you. Don’t be afraid to consult. No one will laugh at you and say you cannot calculate numbers. Do you get me? Once you have got that number, don’t cross the red line. Again, this number is not static and varies over time, with the limits reducing when your business is making less profits and increasing when the business is making more profits and consistently. It’s good to check limits at least quarterly or half-yearly, but if you are extremely lazy (and I pray you are not), at least annually.
- Drawings can have tax implications. I need to warn you that drawings can have tax implications. Don’t shoot back in defense and say it’s your money hence not taxable. I know it’s your money and you don’t need to shout about it. The tax guys might look at it differently, also depending on how you treat it in the books of accounts, and the tax laws in your area of jurisdiction. You need to manage drawings tax efficiently. As a general principle, for partnerships and sole proprietors, drawings are added back to your profit and are then taxed. They are not allowed as business expenses when calculating taxes of the business. They are normally taxed as personal income to the owners. If you earn salaries from the business, and remit PAYE (Pay As You Earn Tax) monthly or periodically, what you have remitted should be deducted from your tax for the year and you pay the balance to tax authorities. Limited companies normally pay dividends out of the profits, and they also pay withholding tax on the dividends.
- Financial discipline is required in managing drawings. My dear entrepreneur, you need financial discipline to manage your drawings. There are some entrepreneurs whose businesses are small and do not make much profit. Such cannot easily see the money to draw and spend. However, there are businesses that are much larger, with significant profits and big moneys moving around the business. These are very tempting, and before you know it some owners and directors with appetite have drawn so much money that they can’t even remember! Such indiscipline can cause severe cash flow problems for the business. Business owners need to keep their personal affairs separate from business affairs. If you don’t stick to the limit as I have mentioned above, you are literally brewing trouble, and when it is ready you will certainly have something strong in your hands to handle.
- Drawing is not an expense – rather it’s a reduction in owner’s equity. Now, don’t argue with the tax man about how drawings should be tax free blah blah blah. In many countries drawings are not business expenses and are taxable. Limited companies to some extent can book some expenses as directors’ expenses etc., but they need to prove that they were incurred for the purpose of the business and are reasonable. So beware, as these can also be added back and taxed. Drawings are not tax deductible. These days people are becoming smarter with tax issues, so you can consult if you like.
- Provide for drawings in your budget and cash flow plan. Last but not least, please provide for drawings in your cash flow budget, assuming that you make budgets anyway. I know some entrepreneurs don’t make budgets or any forms of projections for the future. They prefer to move on like rudderless ships. It’s all up to you anyway. Consider the drawing in terms of timing and amount, so that you don’t plug it in anyhow and cause cash flow turmoil in the business. Do you understand me? Never be an arrogant and disorganized business owner who drives at any day or time to the business accountant, asking for tens of millions in drawings. Never mind the currency I’m talking about. Of course I know this is impossible in some countries, but in others you might even struggle to buy a car with the tens of millions. It’s a diverse world. Isn’t it?
In conclusion, please take care of your drawing habit and culture. Drawings, if not well managed, can adversely affect your business. As a parting shot, I think you might also benefit from my blog entitled Bad money habits an entrepreneur must avoid. Enjoy this new week!
The Wise Entrepreneur