The many forms of profit
The many forms of profit
Think you know profit? You may need to think again. This seemingly simple concept is more complex than you might expect.
October 17, 2024

According to the Oxford English Dictionary, profit can be defined as ‘a financial gain’; specifically, ‘the difference between the amount earned and the amount spent in operating or producing something’. On the face of it, this explanation sounds straightforward, but there are many more layers to the concept.

Recently, we held an internal workshop in which we went around the room, asking each team member (many of whom are trained accountants), the simple question: ‘what is profit?’ Interestingly, each person gave a different answer, and even more interestingly, none of them were wrong.

Understanding profit – and knowing how much you’re making – is hugely important to any business owner. But if this question sparks debate among experienced accountants, who deal with profit every day, it’s understandably confusing for our clients. So… How could each team member’s answer to this question be different but still correct?

This is because although ‘profit’ is an umbrella term, there are many different types of profit – each used for a different purpose, and bringing different factors into play. Here, we’ll run through the four different forms that profit can take.

Accounting profit

Although it’s one of the most commonly encountered, this form of profit is actually the least helpful to look at. It’s calculated in line with accounting standards, meaning it includes adjustments such as depreciation, which reduce the profit but are hard to relate to the real world because they don’t involve a cash outlay. However, because the accounts are prepared in line with strict rules, lenders know they can rely on the data, making it an important measure.

Taxable profit

Unsurprisingly, HMRC sets the rules here. So, although we’ve already calculated your accounting profit, we also need to apply further tax rules to arrive at the final figure for taxation. For example, HMRC won’t recognise depreciation as an expense and instead allows you to claim capital allowances on equipment purchases. It also doesn’t allow tax deductions on certain entertaining expenses, so these will be added back onto your profit figure when preparing the tax computation.

Cash profit

While reviewing accounts and tax returns with my clients, I’m often asked: ‘but where is the cash?’. It can be jarring to see a beautiful set of accounts stating you’ve earned a healthy £150,000 profit, and the tax bill that goes along with it, only to find that it isn’t sitting in your bank account. This is because there are certain cash outlays that don’t get treated as expenses when we’re preparing your accounts and tax returns.

Largely, this extends to the capital element of any debt repayment and anything that you as a business owner have taken as drawings. But for obvious reasons, it’s very important to get a handle on the true cash position of your business. Our Management Reports include a cash summary, which tracks all the cash into your business and all that flows out of it, as well as offering a real-time tax estimate, so you can be sure you’re keeping enough back for when the payment deadline eventually rolls around.

EBITDA

This catchy little acronym setting the forums alight in dentistry stands for Earnings Before Interest Tax Depreciation and Amortisation. Though wordy, it’s a common metric used to value dental practices, and it’s helpful because it strips out the personal nuances that affect accounting profit and taxable profit, to instead offer figures comparable with other practices.

To break this down, dental practices are valued at a multiple times EBITDA. For instance, if your EBITDA is £200,000 and the applicable multiple is deemed to be six, your practice would be valued at £1.2 million. During the calculation, any expenses relating to you as an owner are filtered out, and a clinical pay amount is included. This metric is designed to show the commercial profit of a business, if it becomes associate-led (because as we know, many owners don’t pay themselves a true clinician’s wage). It would be unfair to simply compare two sets of accounts, if one owner has a completely different debt profile or pension contributions setup to another, so using EBITDA means there’s a standard way to value and compare one practice with another.

As with most financial matters, when it comes to profit, the more you know, the better you can turn things to your advantage. By having a good understanding of different profit types, business owners can be sure they’re looking at the right data and using it in the right way. If you’re keen to know more or would like to speak to us about management accounts or accountancy services, just get in touch.

The information contained in this article is based on the opinion of Hive Business and does not constitute formal tax advice. Any tax outcomes will be based on individual circumstances, tax legislation and regulation, which are subject to change in the future. You should seek specific advice before embarking on any course of action. Hive Business does not provide regulated Financial Advice, including advice on investment, insurance or lending products or their suitability for you. This article is provided for information only and does not constitute, and should not be interpreted as, investment advice or a recommendation to buy, sell or otherwise transact, or not transact, in any investment including Bitcoin and other crypto. Any use you wish to make of any information contained within this article is, therefore, entirely at your own risk.

By Hayley Robins ACA Accountancy Director
If you have any questions or comments about this article, please get in touch.
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