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:
(1) Take the profit out of the business (e.g. pay a dividend)
(2) 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 (a so-called opportunity cost”). 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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