The Profit Mirage

Finally! You broke-even and are now paying yourself a salary. Heck, you’ve got even a little profit.  It’s over, you’re good to go and you can relax now. Right?  Not quite.

What is Profit?

Before we go any further, let me define profit for you.  I’m going to use Profit in the Accounting definition; that is – what you see when companies release their ‘Profit & Loss Statements’ for the year.  I’ve briefly discussed Gross & Net Profit before, but suffice to say that Gross Profit is after you take the Cost of Good sold (i.e. what you bought the game for) away from Revenue and Net Profit is what happens when you take away all other expenses.

However, Profit isn’t cashflow (or cash in bank) as I’ve mentioned before.  Profit really only tells you how much you ‘should’ have extra after you pay all your expenses.  It doesn’t cover the capital expenses you incur (which are treated differently in accounting terms), nor does it deal with repayment of loans.  Capital expenses can include purchasing a vehicle, a building or (most relevantly) more stock.

Making Money Work

When a business generates a ‘profit’, they start having to pay taxes.  If you are a small business in Canada, your tax rate is only 12%.   So set that amount aside.

What can you do with the remainder profit?

  • pay it out to your shareholders (generally as a dividend)
  • invest in capital items (e.g. buying a vehicle).  The amount you paid will be depreciated over-time which will show up in your P&L statement as depreciation in later years.
  • invest in new stock
  • repay loan(s)

The Mirage

All that above sounds good right? Except… if you are continuing to grow, you often have no choice but to invest that amount in stock.  Here’s why:

Let’s start with some simple assumptions – last year, you did $200,000 in sales.  You now are generating $240,000 – with a net profit of 5%.  That means you generated a net profit of $12,000; after tax profit of $10,560.

Let’s further assume, you did that with a turn rate of 4 (i.e. you had $50,000 in goods) last year.  Now, this year if you ‘keep’ to a turn rate of 4, you need $60,000 worth of goods (4 * 60,0000 = $240,000).  So, of that after tax profit of $10,560 you just dedicated nearly all of it ($60k – $50k = $10k) to increasing your inventory to handle the increase in business.

Why increase inventory? Well, if you didn’t your customers start seeing stockouts much more often – items they want are never in, no matter when they arrive.  You miss out on sales on regular bestsellers and on hot new games because you don’t have the inventory to keep up.  This can be the start of a nasty decline.

This is why profit can be a mirage.  Sure, your company is profitable – but if you keep having to dedicate more funds to the business to keep up with its growth, the profits never really end up in your pocket.  It’s why capital is so important, having adequate amounts and having access to other forms of capital (e.g. investors & loans).