What Is Profit? (March 2007)

Last Month, I promised to write about “profit”. The term profit, according to www.dictionary.com is the “gain resulting from the employment of capital”.

The key to this definition is “capital”. The term profit the amount earned on the capital deployed in the business. One of the more common measurements of the efficiency of capital deployment is “ROI” (Return on Investment), although there are certainly other measurements.

But in order to measure ROI, one first has to get the profit number on the income statement right. Many times, financial statements fail to capture all of the costs of running a business and therefore one can’t tell from the income statement the true profit of the business.

In big companies, the profit picture can be skewed by transfer prices between divisions as well as overhead allocations from corporate. The staffs of large companies have spent countless hours arguing over these and other issues that can drastically impact the profit of operating divisions.

In smaller companies, the issues are different but the result is the same – an income statement that doesn’t accurately portray the profit picture of the business. Profit can be misstated for many reasons, but below are a few which tend to be commonplace.

o Owners provide “free” labor! It is very common for a business owner to be recording his or her salary at a below market rate. In effect, he or she is contributing labor that makes the profitability of the business appear better than it should.

o Interest free loans! Owners sometimes lend their company money at below market rates or at no interest at all. This results in an inflated profit number. A similar phenomenon occurs with rent when the owner of the business also owns the building.

o Failure to capture depreciation! Machinery wears out and must be replaced. The estimated cost of this should be captured monthly.

o Supplier invoices not posted in a timely manner. The result can be a shifting of profits from one period (month, quarter, etc.) to the next.

o No allowance for bad debt. Most businesses have receivables they can’t collect, but I’ve seen businesses carry these on the books at full value when the likelihood of collecting them is slim.

There are numerous examples, but the key is that by not capturing all of the relevant costs of running a business, the owner(s) can’t know the true profit nor can they know the return on the capital they have invested in the business! Aren’t both worth knowing?
What’s your “profit”?

If you need help with your business, financial plans, or goal setting, please give me a call at (314) 863-6637 or send an email to And, remember . . . Your Cash Is Flowing. Know Where.

Copyright @ 2007 Homza Consulting, Inc.

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