Are you a small business owner? Are you looking to start your own business? The politicians can misunderstand profits, and so can the general public, but you’d better not. Profits are good, not bad; but your business runs on cash, not just profits.
1. Profits are an accounting concept, not actual money.
Yes, they lead to money, in most cases. But profits are sales less direct costs less expenses, three concepts that are all subject to detailed accounting definitions and general principles. Timing can make a huge difference. I can book a sale today and not get paid for six months, so no money yet. And I might have paid the direct costs months ago. And I might pay the expenses months ago or in months to come.
2. Profits don’t guarantee cash.
Again, profits are likely to mean cash at some point, but not always. There are those timing issues built in. And businesses pay out money that doesn’t affect the profits at all, such as buying assets, repaying debts, and paying dividends. Lots of profitable companies go under for lack of cash flow.
3. Profits Aren’t Necessarily More-is-Better
There’s an inherent tradeoff between profits and growth. You as business owner decide whether to spend more on marketing to generate growth, or less on marketing to generate profits. I think real businesses need to find a point of balance. We need enough profits to sustain growth (extra credit: “sustainable growth rate”) and keep ownership compensated for risk. But on the long term, growth is better than profits. And cash flow peace is better than growth.
Bonus Point: Most Newbies Overestimate Profits
The most common mistake in business plan financials from first-time entrepreneurs is overestimating profits. Occasionally there is a high-tech wonder business that yields extraordinary profitability, but that’s almost always just a short-term phenomenon. Real businesses make 5-10% profits on sales. When a business plan shows huge profitability, that’s a sign of not understanding the business, not of an exceptionally profitable business.
If you’re curious, try this link: NYU study on average profitability by industry.
And if you’re curious about why this fourth point is labeled bonus point, I wanted my title to list three, not four. Maybe I’m numbers obsessed. Go figure.