What is Profit and Why does it Matter?

stock-photo-9372306-measure-your-profit“Turnover is vanity, profit is sanity, cash is reality”.

You’ve all probably heard a variation of this phrase, but I find that many business owners have a notion of what profit is, but very few actually understand in depth what their business’ profit is and how it is derived….  This is where a management accountant can help.

Profit is not the same as Cash In minus Cash Out. This is due to several factors.  Perhaps you have to invest in some equipment.  Unless the purchase is financed, then the cash is spent all at once.  But in computing profits, the cost of the equipment is spread over the period that the equipment is utilised in the business.  This is known as depreciation.

Purchasing stock is a similar case.  You may buy in stock in large quantities to achieve bulk discounts, but until that stock is actually sold, it is not shown as a cost in the profit and loss account.  So the gap between paying for stock and it being recognised as a cost of sale might be significant.

Debtor / Creditor Days.  Where a business receives or gives credit, there will always be a timing difference between recognising the sale / purchase and the actual cash in/outflow to which it relates.  The greater your debtor / creditor days are, the greater this timing difference will be.

Long Term Projects.  If your business is involved in projects where effort is expended over a period of time, its revenue should be recognised at intervals in line with the degree of completion of the project at any point in time.  This might be very different from the schedule according to which you raise your sales invoices, which is likely to be driven by commercial factors.  Likewise, where you incur costs in your business but have not yet received an invoice from your supplier, these costs should be taken account of (accrued) in the accounts.

All the examples above are instances where the matching concept should be applied.  This is matching costs and revenue to the period to which they relate, rather than the period in which the related cashflows occur.  Without the smoothing inherent in the matching concept, a business’ profits could appear very lumpy!  Good one month when there is little cash going out; then poor the next month when the bills are paid.  These “lumps” obscure the underlying profitability of a business.

Getting to the “true” profitability of a business by discounting the effects of all these noise factors is what a management accountant can do best.  Armed with a “true” profit figure every month means that important business decisions can be made with much greater confidence of success.