5.3.1 Profit and why it is important

Unsurprisingly as profit or “the bottom line” is the ultimate objective of nearly all business activity, questions on calculating profit or evaluating the profitability of different business decisions are hugely popular questions in both Paper 1 and Paper 2.

But let’s start by answering the simple questions: what is profit and why is it so important?

5.3.1 What is Profit? Why is Profit Important?

How a profit is made

Profit is calculated by subtracting the total costs of making a product or service from sales revenue. A profit is made when sales revenue is greater than total costs for a given time period.

Importance of profit to private sector businesses

For entrepreneurs, profit rewards the risk and effort that starting a new business involves.

For investors, profit rewards the risk of investing in a new business. 

Profit is also an important source of finance, retained profit can be used to pay for future capital investment in a business.

Difference between profit and cash

Let’s use the example of Gai’s Kung Fu Gym to show the key differences.

Extract of Accounts from Gai’s Kung Fu Gym ($) 

Over the course of the year Gai’s Gym is profitable. But he has serious cash flow problems, as he has to pay all of his costs for the year before he receives payment from the gym members in December.

Gai’s business shows it’s possible to have a highly profitable business but also large cash flow problems.

Key differences to remember between profit and cash are timing, and how profit is calculated.

Profit is revenue minus costs usually calculated over the course of the year.

Cash is cash inflow minus cash outflow, usually calculated month by month.

Cash can also include loans or capital invested in a business. Profit comes from revenue only.