In my last post, I wrote that profit is less important than cash flow. However, profit is still important, and for a number of reasons beyond the obvious. This post is an overview of some of those reasons.
Some smaller businesses try to keep profits as low as possible, in order to save tax. However, this practice can make it difficult to monitor their business through their management reports, forcing the business owners to rely on inaccurate methods such as the bank balance and gut feelings. This is particularly devastating to a business during times of growth.
With that out of the way, on to the reasons why profit is important.
Returns for Owners
First, the obvious use for profits; wages, dividends, and/or return on investment for the business owners. This is what most people think profits are for, but there is much more to the story.
Investors want a good return on their investment, whether it is paid out to them or not, and they often view profits as a measure of their return.
Loan Repayments and Impressing Lenders
Only the interest portion of loan repayments lowers your profit, but the business must make enough income to also cover the principal portion.
Lenders need to see regular profits to reassure themselves that the business will be able to repay its loans.
Profit is income less expenses. Here’s another way to look at it: profit is unspent income, i.e. savings. If you want to build up savings in your business, you must have profits.
In simple terms, working capital is the amount of money sitting in the business’ bank account.
The business must leave money in the bank account during the good times, so that there will be enough money to pay expenses during the slow times, e.g. Christmas closures or quiet months.
There must also be enough money to pay for costs until the money comes in from customers. To calculate the funds required by the business in the future, use a cash flow forecast.
Just as for savings, a business builds up working capital using profits.
All assets need to be replaced eventually, so the business needs investors, lenders or savings (see above headings) to fund asset purchases.
Profits help business owners and their advisors determine whether a business can, or should, grow. If the business has very little profit at the current size, it may be even less profitable when it grows. Or a business may only be profitable once it reaches a certain scale, due to volume discounts, high fixed expenses, or large minimum order quantities from suppliers.
Many business growth initiatives require spending money in advance, such as marketing campaigns, asset purchases, or increasing staff capacity. The business needs profits before growing so that it can fund growth initiatives with the help of savings, lenders or investors.
Most businesses will require increased working capital after growth, to manage the new (and perhaps more extreme) peaks and troughs in their cash flow throughout the year. The business needs profits, before and after growing, to fund the new working capital requirements.
That’s a basic overview of a few reasons why profit is important. I still maintain that cash flow is even more important and will post more about cash flow in the future.