what profit is

5.3.1 What profit is and why it is important

Objective

To define profit using the exact Cambridge IGCSE Business Studies wording, distinguish it from cash flow, describe the structure of the income‑statement, identify the profit measures required by the syllabus, explain the concept of retained profit, discuss the limitations of profit as a performance indicator, and outline why profit is a crucial measure for any business.

What is profit?

Profit is the financial gain shown on the income‑statement after all the costs of running the business have been deducted from total revenue. It is an accounting measure of earnings, not a record of cash actually received.

Basic profit formula (syllabus wording)

$$\text{Profit} = \text{Total Revenue} - \text{Total Costs}$$

Profit versus cash flow

• Profit – the surplus shown on the income‑statement after deducting expenses from revenue.
• Cash flow – the actual movement of money into and out of the business during a period.
• Consequences: a business can be profitable but still suffer cash‑flow problems (e.g., delayed customer payments or large capital purchases).

Income‑statement structure (required by the syllabus)

The income‑statement (also called the profit and loss account) follows this order:

1. Revenue (sales)
2. Cost of goods sold (COGS)
3. Gross profit – revenue after deducting COGS.
4. Operating expenses (salaries, rent, utilities, depreciation, etc.)
5. Operating profit – gross profit after deducting operating expenses.
6. Non‑operating income (e.g., interest received)
7. Interest expense
8. Profit before tax (PBT) – operating profit plus non‑operating income less interest expense.
9. Tax
10. Profit after tax (net profit) – profit before tax less tax.
11. Retained profit – profit after tax that is kept in the business rather than paid as dividends.

Key profit measures (exact syllabus wording)

Limitations of profit as a performance indicator

• Ignores the timing of cash receipts and payments – a profitable business may still run out of cash.
• Does not reflect non‑financial objectives such as product quality, customer satisfaction, environmental impact or corporate social responsibility.
• Can be distorted by accounting policies (e.g., depreciation methods, inventory valuation).
• Profit may be increased by cutting essential costs, which could harm long‑term sustainability.

Why is profit important?

• Performance indicator – Shows how efficiently a business converts sales into earnings.
• Source of finance – Retained profit can be reinvested to fund expansion, research & development, or to reduce borrowing.
• Reward for owners and shareholders – Enables payment of dividends and increases the value of shares.
• Reward for risk‑taking/entrepreneurship – Recognises the risk taken by the entrepreneur in starting and running the business.
• Tax obligation – Determines the amount of corporation tax the business must pay.
• Business sustainability – Consistent profitability helps a firm survive economic downturns and remain competitive.
• Decision‑making tool – Managers use profit figures to assess product lines, set pricing strategies, control costs, and evaluate investment proposals.
• Link to other business objectives – Profit is one of several aims (growth, market share, quality, social responsibility). Pursuing profit alone can create conflicts with these non‑financial goals.

Profitability ratios (required later in the syllabus – 5.5.1 to 5.5.4)

Link to break‑even analysis (Section 4.2.3)

The break‑even point is the level of sales at which total revenue equals total costs, giving a profit of £0. Understanding profit measures is essential for:

• Identifying the fixed and variable costs that affect the break‑even calculation.
• Analysing how changes in price, cost or sales volume move a business from a loss, through break‑even, to profit.

Worked example (AO2 / AO3)

Assume a small retailer reports the following figures for the year:

• Sales revenue: £12 000
• Cost of goods sold: £5 000
• Operating expenses (salaries, rent, utilities): £3 000
• Non‑operating income (interest received): £200
• Interest expense: £300
• Tax rate: 20 % of profit before tax
• Dividends paid: £500

1. Gross profit: £12 000 – £5 000 = £7 000
2. Operating profit: £7 000 – £3 000 = £4 000
3. Profit before tax: £4 000 + £200 – £300 = £3 900
4. Tax: 20 % × £3 900 = £780
5. Profit after tax (Net profit): £3 900 – £780 = £3 120
6. Retained profit: £3 120 – £500 = £2 620

Profitability ratios for the year:

• Gross profit margin = (£7 000 / £12 000) × 100 = 58.3 %
• Net profit margin = (£3 120 / £12 000) × 100 = 26.0 %
• Assuming capital employed of £20 000, ROCE = (£4 000 / £20 000) × 100 = 20 %

Key points to remember

1. Profit is an accounting surplus; cash flow records actual money movements.
2. Four profit measures (gross, operating, PBT, net) each serve a specific analytical purpose.
3. Retained profit is the portion of net profit kept in the business and is a key source of internal finance.
4. Profit alone does not guarantee a healthy business – consider cash flow, non‑financial objectives, and the limitations listed above.
5. Profitability ratios help compare performance over time and against competitors.
6. Understanding profit is essential for break‑even analysis, budgeting, and strategic decision‑making.