PROFIT, a term used by business men to describe the result of their operations when that result is favourable. When the result is unfavourable the term loss is commonly used. Strictly speaking, the word profit means "result," whether favourable or unfavourable; but it is obviously more convenient to speak of an unfavourable result as a "loss" than as a "minus profit." As used by business men; the word profit must not be confounded with profits assessable to income tax or super tax. The rules for determining the liability of individuals or companies to these imposts are determined by statute, and are extremely artificial; similarly, profits in the business sense must not be confused with the economist's idea of profit.
If it were practicable for the business man to wait until his business was discontinued and wound up before attempting to arrive at any idea of what his profits were, it would be possible for him to accept the economic definition of profits as "the sur plus remaining over from the employment of capital after defray ing all the necessary expenses and outlay incurred in its employ ment, and after the capital has been replaced or provision made for its replacement." But the business man has to determine his profits as he goes along (I) because in no other way can he de termine the most advantageous way in which to carry on his business; (2) because, in general, it would be impossible to obtain capital for business purposes, save upon the terms of distributing profits not less frequently than once a year, so that those con tributing capital to enterprise may receive in return income by way of dividends. Hence the necessity of determining divisible profits from year to year.
It is absolutely impossible to determine the profits of a going concern from year to year with precision, because nothing more reliable than estimates can then be formed of the value of its outstanding obligations and unrealized possessions. But it would be unwise to distribute the whole of the profits year by year even if they were ascertainable, as were this to be done there would be no margin left to cover contingencies, and experience shows that unexpected losses are bound to occur from time to time.
The problem that besets the business man year by year is not therefore how to ascertain the precise annual profits, but how to determine a figure of profit which can be divided without unduly jeopardizing the future prospects of the undertaking. Further, be cause distributions out of profits are made regularly at definite intervals and are treated by those who receive them as income, it is important that no kind of gain should be treated as divisible profits which by its very nature cannot be expected to recur.
profits are increases of wealth arising from causes not directly connected with the carrying on of the business of the undertak ing, e.g., increases in the value of its fixed assets (i.e., those assets held permanently as part of its equipment), a rise in the market value of which adds nothing to the fund out of which alone divi dends can be paid. Indeed, a permanent rise in the value of fixed assets is a source of embarrassment rather than of congratulation, in that it increases the ultimate cost of replacements as and when such assets are worn out, and thus then at least tends to deplete the fund available for the payment of dividends. Conversely, capital losses arising from a fall in the value of fixed assets do not affect divisible profits so long as these assets continue to be equally effective as profit-earning equipment, while a fall in the cost of renewals is advantageous from a revenue point of view.
Of course, if and when a business is discontinued and wound up, capital losses and profits will materialize. If on balance there have been profits on capital, the fixed assets will realize more than they otherwise would have realized, and a correspondingly larger sum will be available out of which to make a return of capital or, rather, there will be a balance of capital profits to divide after capital itself has been returned in full. Conversely, if on balance there have been capital losses, the fixed assets will not realize a sum sufficient to enable the whole of the capital to be returned, and there will therefore be a realized loss on liquidation. Where the business is owned by a limited company, this means that the shareholders (or the holders of some class or classes of shares) will not receive the whole of their capital back; but if the business bs owned by a concern not subject to limited liability, e.g., a partnership, the members will have to contribute among them the ascertained loss pro rata, according to the shares in which they were entitled to participate in profits, and there will then be a sufficient fund to enable the whole of the capital to be returned to those who provided it.
In the case of a partnership, it is usual to divide the whole of the profits as shown by the annual accounts; but in the case of a company, it is not usual to pay away as dividend the whole of the profits shown by the annual accounts. A part of these profits is normally held back as a reserve against unforeseen contin gencies, and another part is normally "carried forward" partly with a view to equalizing dividends in good and bad years, partly to avoid the inconvenience of paying away profits which have perhaps not entirely been received in cash.