The Importance of Profit to a Business

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Profit is the amount of money remaining after all the expenses of running the business are paid--total revenues minus total expenses. In the short term, a business can lose money and still keep going by drawing on previously accumulated cash reserves. Start-up technology companies sometimes incur losses for several years and use venture capital to fund operations until they reach positive cash flow. But over the longer term, earning a profit is essential to a company's survival.

Reward for Shareholders

  • Profitable public or private companies have cash available for dividends--cash payments--to shareholders. These are often paid on a quarterly basis. Shareholders of private companies may earn an even larger reward when the company is sold and their shares are purchased from them. As a company grows and becomes more profitable, the value of its shares increases. For example, stockholders that originally paid $10 per share might receive $50 per share when the company is acquired.

Compensation for Owners and Employees

  • Achieving and sustaining profitability are the goals of every business owner. Running a profitable company creates the ideal situation for a business owner--he gets the freedom that comes from being the person in charge, the creative challenge of devising and implementing marketing strategies to beat the competition and the opportunity to earn much more money than he could working for someone else. He can also generously reward his most talented employees, which helps him retain them.

Impact on Stock Price

  • Investors pay close attention to the profitability trends of public companies. An important statistic they follow is earnings per share. This number is calculated by dividing the company's net earnings minus any dividends paid to preferred shareholders, by the number of shares of common stock outstanding. Steady increases in earnings per share often result in a rising price for the company's stock. Price-Earnings ratio, or P-E ratio, is derived by dividing the stock's market price by the annual earnings per share. When earnings are increasing and the P-E ratio declines, it can be a signal that the stock is undervalued, encouraging investors to purchase it and bid the price up.

Measure of Growth and Efficiency

  • If pre-tax profit as a percentage of revenue is increasing, it means a greater portion of each revenue dollar earned is reaching the bottom line. This can occur because revenue is growing faster than expenses, or because the company is being managed more efficiently, which can be indicated by a higher gross margin percentage or marketing and administrative expenses that are declining as a percentage of sales.

Cash Flow for Future Development

  • Companies that are perennially successful are constantly seeking new opportunities to build their customer base and increase their revenue. Developing new products or penetrating new markets requires additional spending on plant and equipment, adding new personnel or on advertising and promotion. Profitable companies generate the needed cash to take advantage of new opportunities that arise even if it will be several years before they reap any revenue benefit from them. A company's current success helps bring about future success.

References

  • Photo Credit profit/loss image by Warren Millar from Fotolia.com
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