Are You Really Making Money? Why Profits Don’t Always Add Up

Profits can be deceiving and while the goal for every entrepreneur should be to make a “profit”, this actually can be interpreted in a number of ways.

For instance, founders of not-for-profits often take large salaries and can live a lifestyle far above the average small business owner. And though the traditional idea of a profit might be how much money is left in your pocket at the end of the day, some might view an increase in company value (if you plan to sell) or non-monetary benefits as “profit”. Still others view improvements in lifestyle as a unique kind of “profit” for an entrepreneur.

What Does a Profit Actually Mean?

In its rawest form, a profit is the difference between what you sell something for and how much it costs you to make the item. In reality, this is “gross profit” – only the first-tier in a sense.

Why? Because there’s more to business than just making and selling an item. There are numerous other expenses.

Imagine you’re selling t-shirts at a fair. Your expenses might include the cost of materials to make the shirts, but what else? You’ll have the cost to rent the booth, transportation costs to get you and your shirts to the fair, and other expenses while there, like purchasing overpriced water to stay hydrated. In this case, that’s definitely a necessary business expense!

You probably will also invest in some sort of display materials for your shirts. At the very least, a tablecloth, a brightly colored sign, etc.

And, finally, you must not forget your time. You spent time designing the shirts, creating the shirts, transporting them, thinking through your booth display, and then the time at the fair to do the actual selling.

Once you take into account all of these various expenses, you can find your net profit. The good news is that while your net profit might not look so great after the first fair, it probably won’t be the last event you sell shirts at. If you’ve taken good care of your display materials, these can be used again and again. Thus, you can distribute the cost of these decorations over multiple events.

The same principle goes for every business. You might have costs to lease a building or to keep your website running. These must all be factored in.

For individual entrepreneurs, you may or may not take a salary when you first start. So, your company might show a net profit of $50,000 at the end of the year, but what would it have been had you taken a salary? As an individual, you can consider the combined total of what you pay yourself plus the net profit from the company as your total profit.

However, if you’re pitching to investors, they’ll be looking at profit in the most traditional sense: How much money did the company make after all expenses are factored in? And, if you haven’t been paying yourself a salary, they’re going to include a reasonable estimation in their calculations because, well, you can’t work for free forever.

Another consideration in profit is the value of your company. As you grow your company, depending on the industry, you’re growing the value of your business. How much could you sell your business for? If you made $50,000 in net profits, but the equity of your business also grew by $50,000, then you’ve really created a financial value, or profit, of $100,000. Just like this might be a positive thing that increases your value, you’ll also need to consider this in future years should your business lose value. If you’re bringing in $100,000 in net profits, but your company decreases in value by $50,000, then your net financial gain is only $50,000.

Hand-in-hand with considering the value of your businesses as profit is looking at your balance sheet rather than just the amount in your bank account.

 

Why Net Profit May Not be True Profit

You need to understand the full analysis of your assets and liabilities.  Just because you show a net profit at the end of the fiscal year doesn’t mean that will turn out to be a true profit. Why?

Because if you have outstanding bills owed to vendors at the end of the year, those really must be factored in when you consider your true profit and you can bet an investor isn’t going to forget about this!

It goes the other way as well: If you purchased valuable equipment this year, you may look like you have a lower profit than you’d like. However, that equipment likely did not lose all of its value instantly. Even though you don’t have the cash-on-hand to show as profit, value is still retained as you could liquidate that equipment into cash if you desired.

 

One of the biggest mistakes I see entrepreneurs making is not considering the value of their time.

When you think about even your net profit at the end of the year, you might want to add another factor. Perhaps you left a job that paid $100,000 a year to start your business. If you bring in a net profit of $50,000 (and took no other salary), one might argue that you, personally, made no profit at all. In fact, you’ve lost $50,000!

Of course, if it’s early in your entrepreneur endeavor, that doesn’t mean you should quit. It can take several years to get your business running and growing at its full potential and so though you may bring in less cash initially, you’re investing in something that has the potential to pay off much bigger in the years to come.

However, for most entrepreneurs who aren’t straight out of university, that initial decrease in income is a major factor in their lifestyle and can negatively impact their family in a number of ways.

 

Alternative Kinds of Profit

What about other kinds of profit? That’s right – beyond the traditional dollars and cents of profit, there are other, more unique factors that some consider to be profit.

That $100,000 a year job that you left might have been life-sucking. Maybe you were working 80 hours a week and barely able to see your family. Perhaps your health was suffering as a result.

Some consider other benefits such as a more flexible schedule or the ability to follow your passion as profit. Could you place a value on this profit? It might be something you have to decide on your own. But, you could also draw out mathematical reasoning to determine this value. If you’re able to cut your hours in half, you’re making twice the amount per hour (if you bring in the same income). By staying healthy, you may be saving untold amounts of money in medical expenses. You might live longer. How much is it worth to add more years to your life?

So, what’s the point in all of this? When considering profit, it’s not always what it seems. Sure, traditional profit is the difference between the money you bring in and what you spend, but you can’t simply look at your bank account to determine this.

You have to consider the total picture of the net gain in cash along with any assets, like valuable equipment or intellectual property, and liabilities, like payments owed to vendors. You should also include any change in the value of your company.

You might not be bringing in piles of cash, but the value of your business is growing so that, if you sell it one day, you’re going to make a massive gain. If it takes you 10 years to grow a business to be worth $10,000,000, you might say that you had an annual profit of $1,000,000, even if you didn’t bring that much in cash at the time!

Finally, especially for individual entrepreneurs not looking for outside investments, I would argue that there is sometimes room for unique kinds of “profit” like an improved lifestyle or relationships.

What’s your definition of profit?  I’d love to hear in the comments below!

Author: Brendan Mills

Brendan Mills is the founder of CFO Dynamics and loves helping businesses maximise their financial performance by optimizing their financial processes. His great passion is to help people understand financial information and use it to their advantage, regardless of how much (or how little) financial experience they have.

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