Has the concept of profit been misunderstood?
The importance of a company’s financial performance is emphasized in the current economic situation. As financing tightens, profit becomes the sole source of funding for many companies.
The concept of profit or earnings first requires clarification regarding what is meant by profit.
Net profit: Net profit represents the amount of money a company earns when all expenses are subtracted from total revenue. Expenses include, among other things, purchases, personnel costs, rents, other business expenses, taxes, interest expenses, and depreciation. Net profit/earnings is an essential metric for evaluating a company’s profitability, opportunities to response for their financial commitments and understanding its financial situation.
In this context, profit refers to net profit, which remains in the company after all expenses.
The general public often thinks of profit as the difference between selling and purchasing prices, which in reality is the gross margin. The fixed costs has not been taken into account. An example of this is seen in many auction programs where the difference between the selling price and the purchasing price is mistakenly treated as net profit.
The following diagram illustrates the formation of net earnings:
Another commonly misleading notion is the magnitude of profits. When the media mostly covers large and successful companies, a misconception arises regarding the profitability of large corporate masses.
The book “Vinst*” extensively addresses this issue, also on an international scale.
In the United States, the general public’s perceptions of corporate profits have been studied. The general public usually estimates profits to be 4-6 times larger on average than they actually are. A similar study was conducted in Italy in 2019, where the public estimated the average profit margin to be 38%, while profits were actually around 5%.
Looking at the 2021 Fortune Global 500 list** for the United States, the median company’s profit was 3.66%, even though the top 32 companies generated profit margins of over 20%. It should be noted that corporate profits vary significantly both across different industries and geographically. However, these figures provide an overall view of all companies’ net profit.
As a result, it can be concluded that citizens in different countries estimate corporate profits to be several times larger than they actually are.
According to Statistics Finland’s data for the year 2021, the median entrepreneur’s profit in Finland was about 2.5% of revenue and approximately 2,000 euros in absolute terms. The number of companies was 252,000. Therefore, 126,000 companies had a lower profit than 2,000 euros per year.
The following table depicts the financial situation of companies in Finland from 2019 to 2021. Since the number of small businesses is so significant in this statistical sample, the existing approximately 6,000 large companies are not clearly distinguishable. In conclusion, the statistics best depict the financial state of small businesses. Most of these companies are practiced by sole proprietors.
We also see that a significant portion of these small companies lack the financial resources to hire personnel or invest in significant projects. The median company’s annual revenue was about €85,000, net profit was €2,000, and equity was approximately €18,000. Even for the upper quartile, the profit was around €23,000 per year, with equity of €107,000, and for 189,000 companies, the profit remained below €23,000 per year.
The Ethical Aspect of Profit and Earnings
At times, companies employ unethical means to generate profit and earnings. The highest profits are often made in situations resembling monopolies, such as when pharmaceutical companies unjustifiably raise prices or when utility companies abuse their pricing power. This kind of pricing is not reflective of a normal market situation, and there should be more effective interventions to address it than currently exist. This responsibility falls upon existing regulatory authorities.
It’s important to note that the use of unethical practices rarely pertains to the hundreds of thousands of entrepreneurs who struggle with their daily profitability.
The other aspect of entrepreneurship is facing losses. In this scenario, a company consumes funds from creditors and owners. Prolonged losses often lead to financial problems, causing stress throughout the entire business community. Stress is known to cause both physical and psychological illnesses, which drain both mental resources and societal assets. The final stop is often bankruptcy as a result of losses, which not only deplete entrepreneurs’ and stakeholders’ resources but also cause significant emotional suffering.
From the perspective of employees and society, it’s better to have healthy, profit-generating companies that are willing and able to provide employment and fulfill their responsibilities.
Why should we dedicate more time and resources to generating profits?
1. Ensuring a company’s profitability is not just about becoming prosperous, but also about ensuring livelihoods and avoiding debt-driven poverty.
2. A company requires profits for:
Loan repayments,
Creating a buffer for unforeseen challenges,
Navigating seasonal and cyclical fluctuations,
Expanding operations,
Making investments and paying dividends,
Net profit is a prerequisite for a strong credit rating,
Profit is a survival cost, and earnings are the only assurance of long-term operations,
Investments in well-being and environmental issues require resources and profitability,
Society benefits from the tax income generated by companies,
Company bankruptcy always results in misallocation of resources.
3. The Finnish Limited Liability Companies Act requires, unless otherwise specified in the articles of association, that the company’s objective is to generate profit. This requirement is sometimes questioned, but it’s important to remember that a loss-making company always consumes either the owners’ or creditors’ capital.
4. Different companies have different needs for generating profit. For instance, a debt-free company has a lower profit requirement compared to a company with debts. When evaluating a company’s profit, it’s crucial to be aware of the capital needs the company has.
How to improve a company’s profitability?
There is scientific evidence that focusing on profitability leads to increased earnings.
Time and effort should be allocated to:
Reevaluating the business idea and strategy.
Increasing profitable sales.
Product development (in collaboration with staff and customers).
Evaluating pricing, including assessing discount criteria.
Evaluating costs.
Training management and key personnel on the fundamentals and methods of profit generation.
Entrepreneurs and management are responsible for ensuring that profitability receives the attention it needs in companies.
These actions often require long-term commitment but ensure the company’s long-term existence and benefit society as a whole. The importance of generating profit in companies and the accurate understanding of its significance should be emphasized more at all levels of society, and a clear change in attitude is needed.
–––
* “Vinst: Lönsamma företag går inte i konkurs” by Hermann Simon, Andreas Jonason, Felix Möreé, 2022
** Statistics from Statistics Finland as of April 25, 2023. The statistics include a total of approximately 252,000 companies.