Before you can understand different forms of profit, you must first look at what profit means in business.
What is Profit?
Profit is the difference between the income a business generates and all of the expenses incurred in keeping the business running. Rather than being calculated over a period of days or weeks, profit is usually calculated over several months or on an annual basis.
The Importance of Profit to a Business
A successful entrepreneur has invested time and money at the beginning stages of his or her business venture in the hope that this effort will pay off. There are no guarantees, even with setting profitability goals, that the business will be a success. The money a business makes once all the expenses have been calculated makes the inherent risk in starting and running the business worth it.
In order to have the funds to invest in updated equipment, more staff, and improved training, the business needs to generate a profit. A portion of these funds should be designated for these purposes.
Four Forms of Profit
The four forms of profit are as follows:
Gross profit is calculated by adding up all sales the company generates over a certain period of time and subtracting the cost of producing the products the company sells. In the case of a business that provides a service instead of selling goods, gross profit is calculated by deducting the cost of providing the service before any expenses, such as interest, wages, taxes, or overhead are factored in. This figure is usually used by company officials when making decisions about pricing and what materials to use in the manufacturing part of the business.
This is the term most of us are familiar with. The company determines its net profit, if any, by subtracting all of the expenses incurred in running the business (overhead as well as interest payable) from its gross sales. The net profit for the company is an indication of how the business is performing over time. It is also referred to as "pre-tax profit."
To calculate net profit, the company's bookkeeper or accountant must keep careful records of all of the business income and expenses.
Net Profit After Interest and Taxes
The net profit of the company is further reduced when interest and income taxes are deducted. The company's owners can choose to receive some of this amount in the form of company dividends. A dividend is an amount of money paid to company shareholders. The amount of the dividend will be based on a certain figure for each share in the company the individual owns. Dividends may be paid every quarter or twice a year.
Any profit remaining after the shareholders have received their dividends is referred to as "retained profit." Most of the time, these funds are reinvested in the company. Retained profit becomes an important source of capital for the business.When you hear or read profit figures listed in the annual finance reports of major corporations or are trying to figure out whether your own business venture is making money or operating in the red, there are many factors to be taken into consideration. Becoming familiar with the different forms of profit is crucial to your ability to understand exactly how the business is doing financially.
Looking at gross profit doesn't tell the entire story, and there may be a significant difference between the figure for net profit and retained profit.