Except for nonprofit organizations and charities, anyone who starts a business has one goal: to earn profit.
But, what is profit anyway? Is it the total money in your cash register or your bank account at the end of a given business day? If you think it is, it’s time for you to have a refresher on the basics of finance.
Revenue or profit?
While revenue and profit are often used interchangeably, these terms are different from the point of view of finance and accounting.
Revenue is the total income that is generated from your business activities. It can be in the form of cash receipts and/or receivables (as with B2B transactions where the customer’s payment is deferred), as well as other noncash assets.
Profit is a little more complex since there are different classifications. Gross profit is the amount left when you subtract the cost of goods sold (purchase cost of your product and incidental freight charges) from the total revenue. (Revenue – Cost of Goods Sold = Gross Profit)
Net profit is the amount you get when you subtract all your business expenses from your gross profit. Also known as the bottom line, this amount is an essential basis for assessing the true potential of any business undertaking. (Gross Profit – Business Expenses = Net Profit)
Net profit after tax is the amount you get by subtracting the tax expense/s from the net profit. Net profit after tax is your real profit. (Net Profit – Tax = Net Profit after Tax)
The importance of not spending all of your profit
Because revenue can come in the form of cash as well as receivables or any other assets that are not readily convertible to cash, the same is true with profit. So after calculating your net profit after tax, you should first make sure that you have enough actual cash before spending your profits. Otherwise, you might not have enough cash left over to pay for your operating expenses and be forced to convert your other assets just to be able to pay the bills.
Knowing the difference between revenue and profit will help you determine whether your business is making money or not because while you can have a positive revenue value, your profit can be negative if your expenses exceed your earnings.