Author: Jim Riley Last updated: Sunday 23 September, 2012
Finance - How profit is used by a business
Profit arises when total sales exceed total cost for a period.
Once a profit has been made, the owners of the business have a choice:
Take the profit out of the business (e.g. pay a dividend to shareholders)
Retain the profit in the business – either in cash or by investing the profit into new assets
Most entrepreneurs reinvested or “retain” profits in a business. Why?
Profit is the most important source of finance for a business. It is defined as being an “internal source” in the sense that it is generated from within the business.
Why is profit important as a source of finance? Because it is entirely within the control of the business – it is not provided by outsiders.
Another reason is that retained profits are relatively cheap. They do have a cost – which is the return that the business owners could obtain by taking the money out of the business. However, the true cost of retained profit is much less than paying interest on a bank loan or overdraft.
What can profit be reinvested in? Essentially to help the business grow: e.g.
Additional production capacity
Investment in information technology
To buy more stocks of raw materials and components
The alternative use for profit is to pay it as a reward or return to the business owners. For shareholders in a company, this method is known as a dividend.
A dividend provides a shareholder with one part of his/her return on investment.
The second part of the return comes when the value of the shares in the company increases.
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