Profits: A working definition

What are profits?

I don’t think most of us really understand the concept very well. In fact, I’ll include myself in the number who struggle to understand what profits are.

To illustrate: When you hear that a company made, say, $8 billion last year, what image comes to your mind? –For me, I tend to think: “Oh, wow! They have $8 billion in cash in a bank somewhere–$8 billion that they did not have the year before. “Profits” mean “cash.” That’s what we think.

I’m sure there are more technically correct definitions of the word profits, but here’s a the best working definition I’ve been able to come up with: Profits are any increase in assets for which a business does not have increased liabilities (or debts) other than to the owners. Put another way, profits are an increase in wealth–and (most important to understand–and something I still tend to forget!) wealth comes in many forms other than money!

I say this because, for the longest time, I thought of profits in the same way I thought of a paycheck: profits are the same thing as a paycheck. You take them, bring them to the bank, and buy stuff with them.

But that’s not the case.

How and why are profits not always cash?

Let me illustrate:

If a company like ours–a company that sells books–buys 25,000 books to resell, books that cost $100,000 (wholesale) . . . if, at the end of the year, we have sold only 20,000 of them (in other words, we still own 5,000 books that cost us $20,000); and if have paid for those books (i.e., we have no more debt at the end of the year than we did at the beginning) . . . then we have made a profit of $20,000. The owners of Sonlight Curriculum have more wealth than they did the year before. They own 5,000 more books (worth $20,000) than they did a year ago.

Notice that 5,000 books worth $20,000 are not the same thing as cash in hand! You can’t eat the books. You can’t buy a house with them. If the owners of the company were forced to go out of business next year and had to sell all of those books at one time to another business, I can assure you, it is highly unlikely that they would get $20,000 for them. Maybe they would be lucky to get 25 cents on the dollar, or 10 cents on the dollar. So those $20,000 worth of books would actually bring them only $5,000 or $2,000.

But from the perspective of the United States’ Internal Revenue Service, those books represent a profit–net income–of $20,000. And the business–or the business’ owners–will have to pay income tax on those $20,000 worth of profits.

Another illustration.

If a company makes very large capital purchases–say we buy new carpeting, or fix the parking lot, or purchase really expensive software, or do a lot of other things that any company needs to do in order to maintain itself (buys desks, computers, warehouse equipment, and shelves): if, at the end of the year, we have paid for all of these things and we have no more debt than we did at the beginning . . . then we have made a profit equal to whatever we spent minus the amount of depreciation that the government permits us to take.

The owners of the company now own a physical plant that is in better condition than it was the year before. So their wealth increased. . . . And that wealth, too–the cleaner, newer carpet, the decent parking lot, the desks, the computers, the warehouse equipment, and shelves: they, too, are all forms of profit.

Again, please notice that carpeting, parking lots, desks, computers, warehouse equipment, and shelves are not the same thing as cash! And just as with the 5,000 additional books in inventory, they aren’t “worth” anything except when used inside the business or unless the company is able to sell them. And, finally, if the owners of the company were to try to sell them, they would likely get only pennies on the dollar. So $100,000 worth of carpeting, parking lot, desks, computers, warehouse equipment, and shelves, also, might actually bring the owners only $10,000 or, in an extremely positive circumstance, maybe, $25,000.

But from the perspective of accountants and the Internal Revenue Service, those things all represent a profit–net income. And the business–or the business’ owners–will have to pay income tax on those things. They are wealth. And, at least in the year when they are purchased debt-free, they are also profits and/or income.

The government does, indeed, recognize that their value declines over time; thus depreciation schedules. But depending on what, specifically, we are talking about, it may be up to 30 years before an item, purchased solely for use in a business, can be fully written off as a real business expense and not “income” or “profits” to the business and/or business owners.

Finally, of course, if, at the end of the year a company has more cash than it did at the beginning of the year (and it doesn’t owe any more than it did at the beginning of the year!), then that cash, too, is a form of profits.

My main point: profits have to do with increased wealth; and increased wealth is not the same as cash and it may not even have much, if anything, to do with benefits to the owners of a company.

Next time: How and why this definition is so important to keep in mind.

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