Profit is the bottom line of any business. It is computed as net of revenue less cost of goods sold and expenses incurred. In computing profit, accrual basis and matching concept of accounting is used.
Business entities have different accounting policies and underlining assumptions used in the preparation of financial statements. With this in mind, given the same set of financial data, different profits with be computed using different assumptions and accounting policies.
When a business is said to be profitable, you must be sure that assertion is correct by interrogating the underlining assumptions. Depending on your numbers, a different accountant might arrive at a different figure altogether: Less profitable, more profitable not profitable at all. This simply implies that profit is not an absolute but a subjective figure.
Profit is not a true determinant of the value of a company, when a firm records profit and report profit it does so in its book but the solvency of the firm is what keep the firm going and prevents it from bankruptcy. Therefore, firm management of cash is very vital to the growth and survival of the firm. In cashflow we consider the inflow and outflow of the cash, we follow the cash basis.
When credit sales are made, it is expected that the debtor pay within a definite period. If he fails to pay at the expiration of the expected pay period, the debt may be considered doubtful or even bad after some time. The decision as to whether a provision should be made for bad and doubtful debt is subjective depending on the company’s accounting policy and accountant nuance. Another company or accountant may not make such a provision. Both conclusions are acceptable. But they will result in different statements of profit.
Other two key items that give rise to illusory profits are depreciation and inventory replacement. The purpose of depreciation is to match the expense recognition for an asset to the revenue generated by that asset. Apart from the fact that depreciation is usually calculated based on the historical cost of fixed assets, there are many methods of computation with each giving a different result. Given the same historical data, different depreciation figures may be computed by different entities using different methods and this affects the profit declared. The higher the depreciation figure, the less the profit, and vice versa. Also, given an inflationary situation, some of the profits will be illusory to the extent that they are needed to replace inventories whose value has risen.
Inventory/inventory valuation can impact profit figures a great deal. Inventory may be manipulated to adjust gross profit. This will ultimately impact the net profit declared. For instance, if you undervalue closing inventory, you will have high gross profit and vice versa.
Like depreciation and provision, deferred tax and interest received affect profit but they are not actually received or paid by the organization.
That’s why, as a business owner, you can’t simply look at that figure and go spend the money. You need to ask your accountant questions, to understand exactly what decisions they took to arrive at the final profit figure.
To make an informed decision about how much cash you have to invest in your business, you must understand revenue, profit, and cash flow together to get an overall picture of the financial health of your company.
Ethics in Business (Part 4)