First, let’s start with the definition of profit being profit is the difference that arises when a firm’s sales revenue exceeds its total costs. This can be shown in an equation Revenue-Total Cost=Profit. With profit, there is also different types of profit. One type of profit managers use a lot is operations profit, which is the amount remaining once all fixed and variable costs have been deducted from total revenue, but before tax has been paid. But, what is the importance of profit?
It goes without saying that profits are important to the majority of businesses. Profits are usually assessed in relation to some yardstick – for example, the amount invested or sales revenue.
Profits are important because:
- they provide a measure of success of a business which is important for new businesses.
- they are the best source of finance/capital to invest in expanding the business. See why here.
- they are act as a magnet to attract further funds from investors enticed by the possibility of high returns on their investment.
However, it is not uncommon for a new business to fail to make a profit in the first months or even years of trading. The need to generate profits become more important as time passes. A business ultimately needs to make profits to reward its owners for putting money into the enterprise
Going back to different types of profit, there is possibly a more important measure of profit which is profit after tax, since this is the profit that the business can decide to do what it wants with it. The most important uses to which these profits can be put are:
- payments to the owners of the business, to partners or to shareholders in the form on dividends.
- reinvestment into the business to purchase capital items such as property and machinery.
It is worth thinking about whether the profits of a new business are the best way to measure it’s success. A successful first year of trading may see an enterprise gain a customer base and repeat orders by supplying at competitive costs. This may result in small profits initially, while the business builds a reputation. Profits may become a more important measure of success in the long-term.
An assessment of the true worth of a business’s performance as measured by its profits would also take account of the general state of the economy: are businesses in general prospering or is it a time of recession? They would also take into account any unusual circumstances such as, for instance, the business being subject to the emergence of a new competitor.