Profit and Profitability

• An income statement shows a business’s profit or loss over a period of time
• Revenue is the income received from selling a product
• Cost of sales is the direct cost of making the goods
• Gross profit is calculated by subtracting cost of sales from revenue
• Overheads are the expenses not directly related to making the product
• Operating profit is calculated by subtracting overheads from gross profit
• Other costs include finance costs and taxation
• Net profit is calculated by subtracting other costs from operating profit
• Profitability measures how effective a business is at making a profit relative to its size
• Cash flow and profit are not the same thing
• Cash flow is the net amount of cash coming in and going out, while profit is the amount of money left after deducting expenses from revenue

This module explains the different types of profit that appear on a business’s income statement, as well as the distinction between profit and profitability, and profit and cash. The income statement shows a business’s profit or loss over a period of time, usually a year. It starts with revenue, which is the income received from selling products. The cost of sales includes the direct cost of making the goods. Gross profit is calculated by subtracting the cost of sales from revenue. Overheads are the expenses not directly related to making the product. Operating profit is calculated by subtracting overheads from gross profit. Other costs, such as finance costs and taxation, are subtracted from operating profit to obtain net profit. Profitability is a measure of how effectively a business makes a profit relative to its size. Profit margins, calculated as a percentage of revenue, can be used to compare profitability. Increasing profit can be achieved by increasing sales, reducing costs, or increasing selling price, but each method has its drawbacks. Increasing profitability can be achieved by increasing selling price or reducing costs. However, increasing the quantity sold does not increase profitability as it also increases costs. Overall, increasing profit and profitability is not easy due to the trade-offs involved.

Many people confuse cash flow with profit when studying business. Cash flow refers to the net cash inflow or outflow in a given period, while profit refers to the amount of money a business earns after deducting expenses. It is common for individuals to mistakenly assume that positive cash flow indicates profit. However, this is not always the case. Cash inflow is not the same as revenue, as loans and credit sales may not contribute to profit immediately. Similarly, cash outflow may not occur immediately after a cost is incurred. It is important to understand the distinction between cash flow and profit to accurately assess a business’s financial performance.