Week 1 Profits vs Wealth

Profits vs Wealth

It is important to note that the current profits are not a good measure of owners' wealth. Profits are just an accounting entry that accountants enter in the books. The owners don't actually get them. What owners do get is dividends and capital gains from selling their stock.

Now, don't get confused. All factors being equal. More profits are better than less profits because more profits enable the firm to:

• pay more dividends, and
• invest more money for future growth which drives the price of the firm's stock up which increases the owners' capital gain.

The problem is, more profits now don't necessarily produce more dividends and capital gains in the long run. This is because profits can be increased in the short run by cutting expenses such as employee training, equipment maintenance, quality inspections, and R&D programs. Such actions increase the risk that the firm won't be viable in the long run, which ultimately decreases the owners' wealth. Remember, it's more important that investors (i.e., the public) think the firm will make money in the future (which makes it more valuable now) than for it to make the most money possible this year.

Profits vs. Earnings per Share (EPS)
"Profits" are often referred to as "earnings," and the earnings (or profits) to each shareholder are called "earnings per share," or EPS. In the context of discussing the goal of the firm then, "profits," "earnings," and earnings per share (EPS) are conceptually the same thing.

Profits vs. Cash Flow
It is possible to generate lots of profit, but still go out of business because you don’t have any cash. For example: If you paid $1 each for 1 million beany babies and sold them on credit for $2 each, you could report $1 million in profit. Although, you still wouldn’t have any money until your customers paid you. This could even be a long time if your credit terms were generous. This difference between profit and cash flow is a big thing in finance (more about it later).