What is the role of profit in Business?
A business can simply be defined as an organization that is engaged or involved in the trade of services or/and goods. One of the most important attribute of any business is “Profit”. Profit is the ultimate goal of existence for all businesses. Without the profits no business will stay operational.
According to American institute of business studies (AIBS), the death rate of organizations is found to be “96 % over an interval of 5 years” i.e. 96 % of total organizations that come into business wipe out within 5 years of their operations, this happen because these organizations found themselves incapable of earning or maintaining the profit margins.
A lay man will feel that, whatever an organization earns in a financial year (from sales) is its profit. But actually it’s not that simple. Total amount that an organization earns in a financial year (from sales) is known as annual revenue of the firm. Now when we subtract the total cost incurred by organization in the period of revenue, then we get “net profit figure” for the organization.
The figure of “net profit” can be obtained from the P & L statement of organization, this “net profit” is also known as EBIT i.e. earnings before interest and tax.
No organization can enjoy “net profit” as a whole because it also has many liabilities associated with it. Firstly interest (against the debt/bonds) is required to be paid off from the EBIT as a primary liability. After paying the interest, tax deductions further reduce the figure and we get PAT i.e. Profit after tax.
PAT is the actual profit that comes out in hands of an organization, now according to the dividend policy, organizations pay out the dividend to the preference share holders which leave the organization with PATD i.e. profit after tax and dividend.
Some amount of PATD will then get distributed as dividend to equity shareholders and remaining amount will be ploughed back to business as “retained earnings”.
Total Profit/Revenue – Cost = Net profit (EBIT)
EBIT (Earnings before interest and tax) – Interest = EBT (Earnings before tax)
EBT – Tax = PAT (Profit after tax)
PAT – Preference dividend = PATD (profit after tax and dividend)
PATD – Equity Dividend = Retained Earnings
Importance of profit
• Profit is the revitalization for any business; it participate in expanding the business in the form of retained earnings.
• Profits participate in wealth maximization of organization because when organization earn heavy profits, it gets distributed to the shareholders in the form of dividends which in turn increase the shareholders trust in organization.
• It reduces the dependence upon the debt and also helps in matching all the liabilities that arise out of debt.
• Profits increase the market value of company’s stock, which is beneficial for the investors looking for capital appreciation.
• Profits finance the organization’s long term growth, expansion and diversification plans.
• Profit is an indicator that represents the competitive position of organization.