Every company needs to earn a profit to be successful. A positive bottom line on a company's income statement is an indicator that the business is doing well. That bottom line, or net profit, is essential for the company's continued growth and prosperity. In this article, we cover the importance of profit and how it compares to growth, the different types of profit, and tips for increasing profit.
What is profit?
Profit is the remaining revenue, also known as income, after a company has accounted for all expenses. In small businesses, the profit usually goes directly to the company's owner or owners. Publicly owned and traded corporations pay out profits to stockholders in dividends. A business owner can keep the money or reinvest it into the company to encourage growth and more profit.
Why is profit important?
Profit is an essential outcome of running a business. Often, earning a profit is the company's primary goal. A positive bottom line shows that the company is healthy and performing well. Profit is capital that companies can use for a variety of purposes, like maintaining the workplace or equipment, replacing or upgrading vehicles or other high-cost items, or investing in new products, services or employees. With good profits, businesses can expect to continue flourishing.
Types of profit
Income statements list three primary types of profit. Each type of profit gives company leadership and other stakeholders valuable insight into the health of the company.
Gross profit is usually the first type of profit listed on the income statement, and often the highest figure. Gross profit is the company's revenue minus the cost of goods sold, or COGS. The gross profit helps companies see how much money they've made after accounting for the direct costs associated with creating their product or service. To calculate gross profit, subtract the COGS from total sales.
Operating profit is below gross profit on the income statement. It accounts for both the COGS and the cost of operating expenses. The operating profit helps businesses evaluate how direct costs, like labor and machinery, and indirect costs, like building rent and utilities, detract from profit. To calculate operating profit, subtract operating costs from gross profit.
Net profit is the final profit calculation on the income statement, also known as the bottom line. Net profit is the remaining revenue after accounting for every business expense, including taxes and interest. The bottom line truly indicates how healthy a business is by showing how much revenue remains after paying all expenses and costs. To calculate net profit, subtract tax and interest costs from operating profit.
Companies can use gross profit, operating profit and net profit to calculate their profit margin, or how effectively the company uses its profits. To determine profit margin, divide either the gross, operating or net profit by the total revenue. High profit margin ratios indicate significant profit per revenue dollar, whereas low profit margin ratios indicate poor profit per revenue dollar.
External stakeholders, like investors, can also use profit margins to compare the value of different-sized companies. For example, a large business may have much higher profits than a small business, but the large business may have a low profit margin, meaning the more efficient small business might be a better investment.
Related: A Guide To Profitability Ratio
How to increase profit
Often, businesses are looking for ways to improve their net profit. Companies can take several approaches to increase their profits:
1. Increase revenue
Companies can increase revenue to improve net profit in three ways:
- Raise prices: Increasing the price of products or services will increase total sales and eventually net profits.
- Sell more products: Enticing customers to purchase a higher number of goods or services will lead to a higher net profit.
- Find new customers: New customers will increase profits through higher overall sales.
2. Cut costs
Another method of increasing profits is cutting costs. Companies can assess and minimize direct and indirect costs to reduce expenses:
- Direct costs: These costs are expenses related specifically to the development of the product or service. Direct cost examples include labor and materials.
- Indirect costs: Also called overhead, indirect costs include expenses related to running the business but not specifically to the product or service sold. Indirect costs include rent or mortgage on the workplace and utilities like water and electricity.
3. Remove products
Sometimes companies sell a large variety of products or services. For those businesses, a great method for increasing profits is removing products or services that do not sell well. Discontinuing poor sellers will decrease production costs, eventually improving the bottom line.
4. Reduce inventory
Holding inventory can be costly. Depending on what the company sells, inventory storage may require a separate building and extra employees. Reducing the amount of stock the company keeps on-site can reduce costs and improve net profits.
Profitability vs. growth
Company leaders and external stakeholders may consider whether profit or growth is a better indicator of a company's health. Depending on the company, it can be valuable to consider each factor independently or both together to determine the company's health, as follows:
A positive bottom line shows that the company is earning more than it's spending, which is a good sign that the company will remain successful. This is useful information for investors looking for positive opportunities and company leadership hoping to increase overall revenue. Young companies may not show high profits as they begin their operations. As a business develops a more focused operating model, it can begin to earn higher profits.
Company growth can also indicate a successful business. Growth is a company's expansion through hiring more employees, increasing the number of products produced and sold, and gaining new markets. Company growth suggests the business has enough capital or revenue to expand its operations. Growth is a valuable indicator of company health for young and established companies.
Profit contributes to growth, and growth suggests a positive revenue stream. Both indicators are valuable when assessing a company's overall health and value.
Why is profit important for stocks?
The stock market functions based on reported earnings and forecasted earnings from large public companies. Every quarter, companies announce their earnings or profits. Generally, if a company's earnings are good, their stock value goes up. Companies may also report measures to increase profitability as part of their future earnings forecast, which can also positively impact their company's stock value.