Definition of profit (investing): a financial gain, measured as the difference between the income and the costs of a particular investment or activity.
What is profit?
Profit is measured as:
[Revenue / Income / Turnover] minus [Expenses / Outgoings / Purchases]
I use several terms for income and expenses above, as financial accounting books tend to stick with a single term throughout.
The profit on a particular transaction is the income associated with that transaction, minus the costs associated only with the same transaction.
The profit for business will include all income and all expenses recorded by the business in a given financial period.
Depending on the generally accepted accounting principles applied, the final profit for a company may be referred to by the following labels:
- Total comprehensive income
- Net profit
- Profit after tax
- Total recognised gains and losses
How is profit measured?
Accountants spend a lot of effort in producing a robust profit figure for each financial period. If profit is calculated on a consistent basis, then this makes the profit for each year directly comparable.
Cash versus Income
One distinction that accountants make is between when a cash flow occurs (money enters or leaves the bank accounts) and when the true point of a transaction should be recorded.
It would be easy to simply add up all cash receipts, and deduct all expenditure in a year and display this as a profit figure. However, this would be very misleading for investors, and would not communicate the performance of the business in an accurate way.
The general rule of thumb is that a sale should be recorded as income once the sale has been agreed AND the product or service has been delivered.
For example, many furniture companies offer payment terms to customers which allow the customer to buy now and pay later. This is an excellent way for us to examine the difference between a cash receipt and income.
When the company ships the furniture, it has fulfilled its promise under the purchase order and is therefore ‘entitled’ to the income. Whether the customer pays immediately or after 30 days, it’s at the point of delivery that the sale is made. Therefore accountants will ensure that the sales recorded in a financial period reflect the deliveries made, rather than the value of cash received.
The general principle of accounting for costs, is that they should be matched against the corresponding element of income.
If a company buys a cup of £1 in 2019 (its cost of goods sold), and then sells that cup for £4 in 2020, which of the following profit figures is the most useful?
A) 2019: Loss of £1, 2020: Profit of £4
B) 2020: Profit of £3
The correct answer is B – it’s most useful to ensure that costs are recorded as an expense in the same period as its associated revenue so that the profit figure is relevant.
This cup business makes a profit, therefore the loss of £1 in 2019 is misleading. Likewise, it did have to incur a cost for the cup, therefore, the profit of £4 showing in 2020 looks misleading too.
How is profit used in a sentence?
“The holding company reported a profit of £1.2bn in 2019″
“The profitability of company B has increased since its capital expenditure project improved efficiencies on the production line.”
How does the definition of profit relate to investing?
As an investor, to measure your own returns on your investment portfolio, you’ll want to know how to calculate profit.
One quick way to measure your profit to date is to compare the current value of your investment portfolio & cash, to the total amount you have deposited into your stockbroker and bank accounts over the investment period.
Both of these figures are easily available through your stockbroker platform and your transaction history, so you should be able to calculate a profit in minutes.