Profit

Profit is the amount by which a business's revenue exceeds its costs over a period. It is the bottom line of an income statement, the figure reached after every expense has been subtracted from sales. A business is profitable when this number is positive and running at a loss when it is negative. Profit measures what an activity keeps, which is why it, rather than revenue, is the number that decides whether a business is worth running.

"Profit" is rarely a single figure, because a business subtracts its costs in layers and each layer produces a meaningful number. Gross profit is revenue minus the direct cost of the goods or services sold, and it shows whether the core product is priced above what it costs to make. Operating profit subtracts the cost of running the business, such as rent, salaries, and marketing, and shows whether the operation as a whole pays for itself. Net profit subtracts everything that remains, including interest on debt and taxes, and is the amount the owners are actually left with. When someone says a business "makes a 10% profit," it is worth asking which of these they mean, because the three can tell very different stories about the same company.

For a business, net profit and net income are the same number, approached from two vocabularies: accountants tend to say "net income," and owners tend to say "profit." A margin restates any of these as a percentage of revenue, so a business with $1,000,000 of revenue and $80,000 of net profit has an 8% net margin. Margins let you compare businesses of different sizes, and they are where the difference between a fragile business and a durable one usually shows up.

The point that trips up new owners is that profit is not cash. Profit is measured on the accrual basis, counting revenue when it is earned and expenses when they are incurred, while cash is measured by what has actually moved. A business can be profitable and still unable to pay its bills if customers are slow to pay or if profit is tied up in unsold inventory, and it can show a loss in a month when a large amount of cash happens to arrive. Profit answers "did we make money?"; cash flow answers "can we pay what we owe right now?", and both questions matter.

Profit is built by subtracting costs from revenue in stages. Consider a small furniture maker over a year, using hypothetical numbers:

Revenue is $200,000. Subtract the direct cost of the wood, hardware, and shop labor that went into the pieces sold, $80,000, and gross profit is $120,000. Subtract the cost of running the business, such as rent, insurance, and marketing, $70,000, and operating profit is $50,000. Subtract $8,000 of loan interest and taxes, and net profit is $42,000.

So the same business honestly has a "profit" of $120,000, $50,000, or $42,000 depending on which layer is meant. Its net margin is $42,000 divided by $200,000, or 21%. And note that the $42,000 of net profit is not necessarily sitting in the bank: if some of that year's sales were on credit and have not been collected, or if cash went into building up inventory, the account balance can be far lower than the profit figure.

Profit is a measurement, so this lists what it does and does not capture.

What profit tells you

• Whether a business actually makes money, not just whether it is busy.
• At each layer (gross, operating, net), where the money is being kept or lost.
• As a margin, how one business compares with another regardless of size.

What profit does not tell you

• Whether the business has cash on hand. Profit is not the bank balance.
• How stable the profit is. A single good contract can flatter a year.
• Anything by itself. "Profit" with no label leaves out whether it is gross, operating, or net, and the three can differ enormously.