Plow back describes the reinvesting of a company’s profits back into the business instead of distributing them as dividends to shareholders.
This can refer to the full amount or a portion of profits being retained.
Smaller companies that are focused on growth tend to plow back their earnings so that more funds can be used towards expanding the business.
The objective is to increase the value of the company.
Shareholders would then profit from capital gains rather than from dividends.
Investors can often see this as a better way to make their money work for them, especially when a company has great growth potential.
This is because reinvesting profits would (in theory) compound the capital gains. Getting profits distributed back to them denies them the opportunity to reinvest the money collected.
Shareholders can of course, use the money to purchase more shares. But that would mean buying them at the current price, which could be much higher than the price they initially paid for the shares they already own.
They would incur transaction fees such as commissions charged by remisiers.
The plowback ratio, also known as the retention ratio, show a quick overview of how much profits retained by a company instead of being distributed as dividends.
It is calculated with the equation:
A 80% retention for example, would mean that every $10 of profits that the company made, $8 is retained and $2 distributed as shareholder dividends.
Young startups tend to have a higher earnings retention ratio compared to more established and mature companies.
Tax implications
Another reason why companies might find it beneficial to retain profits and spend it instead on growth is that when profits are accounted for, it would be taxable under corporate tax rates.
This means that the profits would incur a tax expense before being distributed to shareholders.
For example, a profit of $100,000 might have a 20% tax rate. Leaving $80,000 after tax.
If the profits are reinvested into the company as retained earnings, then this $100,000 can be used by the company for operating purposes without being taxable.
So instead of paying out the $80,000 to shareholders, $100,000 can be reinvested for company growth.
This can potentially leads to even more profits the next year.
Technically, a company would be able to repeat this process year after year. But it would also mean that the shareholders would be denied dividends during the period.
And when profits are eventually booked in, then the tax rate would apply to the profits.
So if the government announces very favorable tax rebates for a particular year, a company might then choose to account for profits to take advantage of the tax break.
From another point of view, a company might choose to plow back when it forecast a loss making year ahead. This can help them avoid tax legitimately in view of a loss making year.
For example, if a company has profits of $50,000 in the current reporting year but forecast a $30,000 loss making year next, then retaining the $50,000 as retained earnings would allow them to offset the $30,000 loss next year.
Eventually leading to a smaller payable tax.
For example, if the company is to declare a $50,000 profit at 20% tax, it would have to pay $10,000 in corporate tax.
But if they plowback the profits for the next year, the $30,000 loss would be covered by the retained $50,000. Leading to a $20,000 profit instead.
Tax will then be calculated on the $20,000, working out to be $4,000.
This in effect, helps the company save $6,000 in tax expenses just by retaining the profits and using it for working capital in the next year.
It is best to seek the advice of a qualified accountant when these issues are on your mind.
