How does increasing profit help a business?

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Increasing profit provides more money for a business. Since making money is the reason most businesses exist, it stands to reason that the more profitable they are, the more successful they will become. Profitable businesses generate more money to pay employees, reinvest in equipment, spend on marketing/promotion (which keeps the...

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Increasing profit provides more money for a business. Since making money is the reason most businesses exist, it stands to reason that the more profitable they are, the more successful they will become. Profitable businesses generate more money to pay employees, reinvest in equipment, spend on marketing/promotion (which keeps the profits coming), give to charity, fund future expansion, or simply keep as cash reserves.

If the company is public, increased profitability typically raises its stock price, making the company more valuable in the eyes of its stockholders. Since businesses borrow money based on their perceived value, it again stands to reason that increasing profits will increase net worth and enhance reputation of a company. This depends, however, on several factors. It's important to consider how the company increased its profits. Was it due to layoffs and cutbacks? Predatory pricing practices? A price increase that proved unsustainable?

For example, suppose you read that Company XYZ increased profits twenty percent this year. That sounds wonderful. But you have to compare that performance to the previous year—or even the previous five or ten years—to put that increase into context. If profit increased twenty percent this year after declining thirty percent last year, that leaves the company behind where it was a year ago. Had you bought stock in that company last year, you would be losing money, despite the impressive profit gain.

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Profits are defined as the difference between the income of a business and its expenses.  Increasing profits is important for a couple of reasons.  First, if a business is not making a profit over time, then it will more than likely go out of business.  Profits reward the owners of the business, whether it be private owners  or shareholders in a company that are rewarded with higher dividends.

If profits are not returned to the owners, they are usually reinvested in the business.  This can have a positive effect .  It can lead to new or improved products for the business.  It can also mean better working conditions for employees and better wages.  Profits can also be used altruistically by helping local communities, which could mean positive feedback from the public and increased business.

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To me, the most important ways in which increasing profits helps a firm are these:

  • It does, of course, increase the value of the business.  If the firm is privately owned, the profits go directly to the net worth of the firm.  If it is publicly traded, it allows the firm to increase its dividends (if it wishes) and it most likely allows the price of shares in the company to increase.
  • It also allows the business to expand if it so desires.  The firm can use the extra profits to invest in new equipment or new stores or whatever other sorts of new inputs will help them to grow.
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