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‘Profit’ can mean different things to different people

by | Sep 11, 2021

One of the biggest problems when trying to understand small business accounting & finance is the terminology. The rules that define accounting (yeah, there’s rules. They’re called GAAP and IFRS and are just as lame as you’d think they are) very specifically define all sorts of accounting terminology. But, some of those accounting terms also have a much broader colloquial, everyday definition. For example, accounting terms like Receivables or Payables aren’t really used outside of their accounting definitions. But, terms like revenue and expenses are used in everyday conversation. And, their definition in accounting is different than their definition in real life.

The worst one of these is the accounting term – PROFIT. While accountants will typically mean ‘net profit as defined by accounting’ when they say ‘profit’, most other people don’t. Everyone has a slightly different definition. And, depending on your definitions, you could be having very different conversations. You should know what true accounting profit really is (so you can understand Profit & Loss reports and what your accountant is talking about) and also be aware of what other people’s definitions might be to make sure you’re on the same page when chatting about your businesses.

 

Accounting Profit (aka net profit):

Accounting profit is revenue minus expenses, as defined by accounting, and is typically found at the bottom of your Profit & Loss. The confusing part here is that accounting revenue isn’t all cash inflows and accounting expenses aren’t all cash outflows. For example, transactions like loan principal (both received and repaid) and owner’s draw/distribution aren’t considered revenue or expenses. To make things even more confusing, legal nuances can affect certain expenses and change the way they’re reported (like with taxes and retirement accounts). That makes accounting profit incredibly difficult to figure out without a Profit & Loss report (even for accountants) and you’ll never be expected to casually know it. But, this is the profit your accountant, banker, and the IRS are referencing when discussing your small business finances.

Most frequently used by: accountants, bankers, insurance agents, finance professionals, IRS, other taxing authorities

 

What’s left in the bank :

What’s left in the bank (aka after all your cash inflows and all your cash outflows) is frequently what people mean when they say profit. After all, it’s all your revenue minus all your expenses, when you use normal everyday definitions. While it’s okay to use this definition when talking to other business owners, you don’t want to use this definition when talking to bankers or trying to get a loan. And, the difference between ‘Accounting Profit’ and ‘What’s left in the bank’ is where a lot of your surprise tax bill comes from. You feel like you didn’t make any money because there’s nothing left in the business bank account, but accounting (and the IRS) say you diddd make money and should be taxed on it.

Most frequently used by: small business owners while talking small business finances with their accountants

 

Owners compensation:

Owners compensation is all the ways you’re paid by your business. Depending on your legal structure, that can include payroll, draw/distributions/dividends, reimbursements, employee benefits, and all those expenses you put on your business card that weren’t really business expenses. And, because we all started our businesses to earn a living and pay ourselves out of the profits, owners’ compensation and profit are sometimes used interchangeably, even though they technically mean different things. There’s no harm in thinking about your pre-tax take-home as your business profit, especially when you’re a freelancer or smaller business. But, as you grow, it becomes a less useful way to gauge your business.

Most frequently used by: freelancers, micro-business owners, sole proprietors, businesses without a defined cash disbursement plan

(Quick note: Owners compensation can be incredibly complicated, especially in the context of S-corps and/or retirement accounts. Don’t use the above definition in those contexts.)

 

Top-line, Gross Revenue :

Gross revenue is your revenue before any expenses whatsoever. And, every now and then, you’ll meet someone who says profit but really means revenue. It’s very difficult to gauge business success based on revenue alone. Revenue doesn’t explain efficiency, growth, or how much is left over at the end of the day. And, two businesses with the same profit can have vastly different revenues. For example, construction and retail businesses will have huge materials and inventory expenses compared to your average professional or creative services business. But, you can even have huge variances in the same industry. For example, you could have two identical marketing agencies except one pays for their clients’ ad spend and is reimbursed while the other charges it directly to the clients’ card. The agency that’s reimbursed will have significantly higher revenue and an ad expense to match.

Most frequently used by: new business owners, gurus, people trying to flex on the internet

 

Profit per hour :

Profit per hour doesn’t appear on any traditional accounting reports and is rarely discussed. But, it’s very important when considering the efficiency and success of your business and deserves a mention. When thinking about your profit (whether it’s accounting profit, what’s left in the bank, owners compensation, whatever), consider how much time that took to earn. $100,000 profit working 60 hours a week is very different than $100,000 profit working 20 hours a week. Adding the time factor to your profit gives it extra depth and meaning.

Most frequently used by: me

 

Hybrid definitions:

There are probably dozens of other hybrid definitions (not to mention, other niche accounting profits like profit per project, gross profit, or EBITDA). The point of all this is just to be aware. Make sure you’re using the same definitions when talking to accountants and other business owners. And, make sure you’re consistently using the same definitions when thinking about your business. Switching definitions from month to month will make it very hard to understand your own business.

 

Action Item:

Generate a Profit & Loss report. That profit number on the bottom is your accounting profit (assuming your bookkeeping is correct). That’s what your accountant is always talking about and what the IRS wants to tax.

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