Profit is the difference in revenue and the expenses. Profit can be deemed as the life blood of all businesses and one important factor in determining the health of a business.
The suceess of any business depends heavily on whether it can acheve profitability and how long it will take for it to do so.
If a business takes too long to achieve profitability, it might not have the required funding or attract enough investments to sustain it till it eventually turns a profit.
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Why is profit important in Business?
Profit is the primary reason for running a business. Hence, if a business fails to turn a profit – it might as well be an indication that a business is yet to reach its purpose. Profit is capital for businesses to do a lot of things, some of which are listed below.
Importance of Profit to a business
- Financing Growth
Growth isessential to every business no mater how small or how big. Growht meant increase in assets, inventory, rolling stock etc and all this depends on increase in equity. Equity increases solely on proft. Profit is a big driver of growth in businesses.
- Measures the effectiveness of the management
A good management is one that is able to manage a business profitably. Profit earnings is one fast way for outsiders/investors to measure the effectiveness of the management team.
- Increases creditworthiness
Banks, other financial institutions and individuals will be more favorably disposed to lending money to a business that is making profit.
- Attracts investor interest
Investors are mainly interested in the profit a business is currently earning or has the potential to earn and the ability to continually earn the profit.
A business that earns profits only in one quater in a year and turns a loss in every other quarter will not earn investor interest as it is unable to prove that it understands how to make profit.
A business that is able to continually earn profit and a clear oath to continues to earn those profits is seen as good investment option.
- Hire Employees
A business that earns a profit will have more lee way to hire new employees as oppposed to a struggling companies.
- Increase market value of the business
In determining the market value of businesses, profit is a much more important factor as oppossed to assets.
Some businesses can be valued at 2x -8x their annual profi while for software businesses, it can be as high as 10x their annual profits, this is due to their abulity to scale rapidly.
Types of Profit
If you have an income statement in your hands, you might have three types of profit
This can be regarded as raw profit that takes into account only the directs cost associated with producing the goods and or service.
Gross profit is revenue minus the cost of goods sold, COGS.
This is the profit that comes below the gross profit in the income statement.
Operating profit accounts for the the cost of operating the business directly in form of labor costs machinery, software subscriptions etc. and indrectly in form of rent and utilities.
Operating profit is calculated by subtracting operating expenses from gross profit
This is the last type of profit in the income statement. It can be regarded as the true profit of the business.
Net profit accounts for every business expense in the time frame which the profit is made. Net profits subtracts expenses such as taxes, interest, debt servicing, legal services etc from the profit.
A positive net profit is the true measure of a business making profits.
Profit margins is a metric used to determine the how effective a business is in utilizing its resources. If a business spends more to achieve very little, its profit margin would be low and vice versa
Profit margin is calculated by dividing either gross profit, operating profit, or net profit by total revenue, High profit margins signify that the business is generating good profit per dollar spent while low profit margins indicate the business is bleeding too much cash and earning too little.