The Business Blog

Profit is the measure with which the performance of a business is valued by investors and taxed by government. Otherwise, it may be ignored – or is it also a primary mechanism for managing people?

The great majority of people working in business are not overly concerned with profit, it is just something that happens, often in mind-boggling numbers. Any individual person’s contribution, even if it were measurable, is swamped. People setting out in business for themselves tend to ask two questions – at the outset: ‘How much profit should we expect to make?’ and, after a period of trading: ‘Where is it then?’

Neither question is easy to answer, but the second can at least be interpreted; it often means: ‘The accountant has said we have made a profit, so why is there no money in the bank?’ The explanation is that profit is not necessarily cash.

Accounting profits
There is something definite about cash.1 Something called a bank statement provides immutable, independent evidence of its existence. Provided it is error-free, you can’t argue with a bank statement. Profit however, as measured in the accounts of a business – the bottom line of the Profit and Loss account – is the result of a number of conventions. It is noteworthy that the definition of business does not include the word ‘profit’, and indeed, in a world without taxes, an independent business could continue quite happily without knowing whether it made an accounting profit, so long as it always had enough cash to pay bills and the proprietor’s wages. The Inland Revenue thinks differently, and insists on a profit calculation which it uses as a basis for corporation tax on companies and schedule D income tax on unincorporated businesses. Self-employed people generate profits from their trade or profession which are subject to taxation independently of how much they transfer from the business to their personal bank accounts.

Another group of people are interested in profits, namely those individuals and executives who are collectively known as the stock market. They like to see the companies in which they invest showing profits. Economists have long since recognised that cash is ultimately what matters for any size of firm, and the more applied amongst them have developed theories that the stock market value of a firm is equal to the discounted value of all its future cash flows. The stock market, meanwhile, continues to think that the price of a share should be some multiple of its earnings per share, which is, roughly speaking, the accounting profit divided by the number of shares in existence. This multiple is called the P/E or Price-Earnings ratio.

The interests of these various bodies give rise to potential accounting schizophrenia in that, from a perspective of liability to taxation the firm would naturally enough want to show the lowest possible profits. On the other hand, from a perspective of obtaining the highest share price, the profits should be as great as possible. Private firms, mostly but not exclusively small, tend to follow the former route, and ideally would like to prepare a different set of accounts for the Inland Revenue than for their bank manager. (To some extent, this has been achieved in effect by the preference of the bank to lend on the basis of cash flow forecasts.) It is said that before Manchester United Football Club received a stock market listing, the chairman’s principle objective was to avoid paying corporation tax. In those days, the sale and purchase of players were shown as entries in the Profit and Loss account, so, to avoid tax, Man Utd would simply buy some more players! Now that it is a quoted company, it wants to show itself in the best light which, as for other listed firms, means reporting good profits. (Interestingly, its football results are better as well.)

The above hints that manipulations of profit figures take place, and they do – but this is a whole area beyond our current scope. Even before any creative accounting takes place, profit is a dangerous concept, because it is part of the going concern principle. Profit is the difference between revenue and expenses. Revenue is income generated from sales to customers, but they do not need to have paid for their purchases to be counted. Under principles of accrual accounting, sales take place at the point the customer takes delivery of the goods, and this is counted in the accounting period when it happens. Expenses, for the Inland Revenue’s purposes, must be incurred ‘wholly and exclusively’ for the purpose of the associated sale, and while the accounting definition may perhaps be a little looser, it is entirely possible that the firm has incurred other expenses which are not part of this profit calculation. The obvious case is where the firm has obtained or produced a large quantity of stock, which, on the principle that it will one day be sold, is given a value that could not be instantly realised. Methods of valuing stock are to some extent flexible, and with enough flexibility, a range of profit figures can potentially be produced. With small firms, the Inland Revenue has the advantage of statistical information from many tax returns and tends to query claims outside the usual range.

It is not unusual for the type of small firm owners who rely totally on their accountants to prepare figures for them, upon being told that they have made a profit, to ask where it is. With larger firms, year on year differences are usually proportionately smaller, and the working capital changes mentioned above are more limited in their effect on the divergence between profit and cash. There is another respect in which profit differs from cash, that of the depreciation charge. This is included in expenses, but it is not a payment from the bank account. It is an adjustment for a payment that happened some time ago. Consequently, when other things are equal, profit understates the cash generated from trade. It is the convention amongst corporate strategists to talk of a company’s cash flow, this not being a reference to the statutory document called the cash flow statement, but a more useful measure of what the business is actually achieving from its trading activities. In most cases, most of this will be reinvested to appear as growth in assets.

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