Profit is more than a math equation — it’s the foremost signifier of a business’s success. That’s part of why it’s so important across small, medium, and large organizations alike.
Achieving a profit should be one of your ultimate business goals, even if you just got your certificate of formation filed. But it’s not simply the definition of profit that’s important. You need to know the various profit measures, understand what they mean, and determine how you can increase your own accounting profits.
What Is Profit?
Profit is total revenue minus total expenses, costs, and taxes and serves as a key indicator of a business’s financial health and operational efficiency. There are different ways to measure revenue and expenses, but the essence of profit remains the same no matter the metric. If you aren’t profitable — meaning you have more expenses than revenue — that’s generally a high cause for concern, as this may indicate your business has an expiration date. If you are profitable, your company is beneficial to shareholders and holds the possibility of scaling.
While it is possible and common for a business to continue operating for a while without being profitable, especially when the business is newer, this isn’t sustainable in the long term. There’s a reason most businesses in the United States fail after just six years. If you want to stay in business, you eventually need to turn a profit — simple as that.
Key Takeaways
- Profitability is a key signifier of a company’s goals and success.
- There are multiple profit measurements, including gross profit and net income.
- Profits are increased in two ways: increasing revenue and decreasing expenses.
- Profitable companies attract investors since they can provide dividends to their shareholders.
Profit Explained
Profit is the financial benefit realized when the revenue a business generates exceeds its costs, including operational expenses, administrative costs, and the taxes involved in the maintenance of business activities. It isn’t the sole indicator of a business’s success, especially when the business is new, but it is a perennial metric of performance.
A new business usually isn’t profitable at first, but that doesn’t mean the business isn’t working. With most of a business’s first-year earnings typically being used to pay expenses and reinvest into the company, it usually takes three to four years for a business to become profitable.
In the end, however, profit is what separates a business from breaking even — when income and expenses are equal, meaning there is neither profit nor loss — or operating at a financial loss, ensuring your business can continue.
What Profit Means to Businesses
Earning money is the primary goal of all for-profit businesses. That’s why profitability is such a big signifier of a business’s success. But profitability is more than a success barometer.
Profit lets businesses reinvest into themselves. When a business owner reinvests profit into the organization, that money becomes an expense of sorts, but a beneficial one — it’s different than standard operational expenses because it allows a business to grow and increase its value, and it’s a form of capital that doesn’t rely on debt or outside investors. Similarly, profits attract investors since their investment can be returned to them in the form of payments known as dividends, a portion of an organization’s profits paid to shareholders.
Profitability also helps companies benefit their team members through a profit-sharing plan. This retirement contribution plan gives team members a percentage of the business’s profits based on quarterly or annual earnings. While contributions are made by the company only, this plan can provide team members with a sense of ownership in the organization.
The importance of profitability to a business or organization depends on the structure. So while limited liability companies may place an extreme emphasis on increasing profits year over year, low-profit limited liability companies can only make a profit so long as the charitable reasons for which they were created remain the highest priority. Similarly, charitable organizations exist solely for charitable purposes, and nonprofits — which, contrary to their name, can actually make a profit — are formed to serve a government-approved purpose, not to generate income for owners or shareholders.
Measurements: Gross, Operating, and Net Profits
While general profit is total revenue minus total expenses, there various types of measurements that provide different insights. Here are some commonly used important profit measures.
- Gross profit. Gross profit is equal to sales revenue minus the
cost of goods sold (COGS). Put
another way, this is the revenue remaining after deducting expenses directly related to
the production or purchase of your goods.
Gross Profit = Revenue - COGS
This measurement, along with the gross profit margin (the percentage of revenue that can be converted into gross profit), is often used to evaluate how efficiently an organization uses resources for producing goods or offering services to clients.
- Net income. Net income is equal to your
total sales revenue minus total expenses, including tax, operating expenses, interest,
and COGS. This is also known as net profit after tax or earnings after tax.
Net Income = Revenue - COGS - All Other Expenses
Net income is a business’s total profitability. It is often used in three ways: to invest back into the business, to pay off debts, or to pay out dividends.
- Retained earnings. This is your company’s net income minus payable
dividends to shareholders.
Retained Earnings = Net Income - Payable Dividends
Retained earnings is the amount of profit a business can tap into for present use or save for future use.
- Earnings before taxes (EBT). Also referred to as net profit before tax,
this is equal to your sales revenue minus COGS
and all expenses except for taxes.
EBT = Net Income + Taxes
EBT helps analyze a business’s profitability before taxes are taken into account, making it easier to compare organizations in different states or countries where the tax rates may differ.
- Earnings before interest and taxes (EBIT). Also known as operating
profit, this is your sales revenue minus COGS and all expenses except interest and
taxes.
EBIT = Net Income + Interest + Taxes
This measurement, like the operating margin, is used to evaluate the performance of a business’s core operations without the cost of interest on debt and tax expenses.
- Earnings before interest, taxes, depreciation, and amortization
(EBITDA). This is your sales revenue minus COGS and all expenses except
interest, taxes, depreciation, and amortization.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
This measurement can be used to compare and contrast the underlying profitability of organizations regardless of factors such as their capital structure or tax situation.
How to Increase Profits
While there are countless products and services you can provide to earn money, there are essentially two ways to maximize profitability:
- Increase revenue. Whether it’s increasing the number of sales, raising the price of products and services, or introducing new products and services without exceeding what you spent to create them, continuously increasing your revenue is imperative to achieving and sustaining long-term profitability.
- Decrease expenses. Even if your revenue stays the same, lowering your expenses will increase your net income. This can look like buying items in bulk to minimize COGS, cutting down on administrative costs, or investing in enterprise resource planning (ERP) software that does the job — and saves you the cost — of numerous other digital products.
Sometimes, increasing revenue can mean increasing expenses. For example, hiring a team member whom you believe can elevate your team and increase the revenue you generate could raise your current expenses. But if such an action increases your revenue substantially more than it increases your expenses, it can be well worth it.
Within the broad umbrella of increasing revenue, there are specific avenues you can explore regardless of industry. For example, your business can further cultivate relationships with customers to increase the amount of repeat business attained. Alternatively, you can target new customers and widen your overall customer base. Alongside either route, or both, you could also take steps — create product bundles, upsell at the purchase point — to increase the average transaction size.
There are also ample cross-industry avenues for increasing profit by decreasing expenses. Eliminating business debt, for instance, can save your organization from having to pay compounding interest expenses. You can also cancel any business accounts or subscriptions that aren’t being used, or purchase software that combines two or more of the accounts you actively use at a lower total cost.
Show Me the Cash (Flow)
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All in all, profit is more than a simple math equation. But when you know its importance and understand the varying profit measures to keep an eye on, you can help guide your company to its goals accordingly.
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Profit FAQs
Where does profit come from?
Profit comes from your company’s revenue. It is the revenue that remains after expenses have been deducted.
How are profits taxed?
Profits are taxed as a business’s income. The specific state and federal taxes a business faces will depend on the business type (i.e., corporation, LLC, partnership).
Why is profit important for stocks?
Companies that are profitable are more attractive to investors since they can pay dividends to their shareholders.
