Understanding Business Accounting For Dummies, 2nd Edition (80 page)

Net income
, or net profit as it is often referred to, is the bottom-line profit that the business earned this period (or, to be more precise, the period just concluded, which often is called ‘this period' to mean the most recent period). This figure is the starting point for determining how much cash - if any - to distribute to the owners. Businesses are not legally required to distribute any of their profit for the period, but if they do distribute some or all of their profit, the amounts distributed to each owner depend on the business's ownership structure, as described in the following section, ‘What Owners Expect for Their Money'.

The owners of a business, in a real sense, stand at the end of the line for their piece of the sales revenue pie. How can you tell whether a business is doing well for its owners? What's a good net income figure? One test is to compare bottom-line profit with sales revenue. Dividing profit by sales revenue gives the
profit ratio
, which is expressed as a percentage. Many people don't really know what's a typical profit ratio for a business. They think it's high - 20 per cent, 30 per cent, or even 50 per cent of sales revenue. In fact, the large majority of businesses earn profit ratios of less than 10 per cent.

Although profit ratio is a useful test of profit performance, it ignores the amount of capital the owners have tied up in the business. Every business needs owners' capital to invest in the assets needed for making profit. The ratio of profit over owners' equity is called
return on equity
. To calculate a business's return on equity
(ROE) you divide net income by total owners' equity (you can find owners' equity listed on the business's balance sheet). Compare the ROE of a business with the ROEs of investment alternatives that have the same kinds of risks and advantages when you're deciding whether to invest in a business. Business managers keep a close watch on their ROE in order to judge their business's profit performance relative to the amount of its owners' capital being used to make that profit.

Usually, managers have an ownership interest in the business - although in large, public companies, managers usually own only a small percentage of the total owners' equity. For a small business, the two or three chief managers may be the only owners. But many small businesses have outside, non-manager investors who put money in the business and share in the profit that the business earns. Chapter 14 explains more about ROE and other ways outside investors interpret the information in a business's external financial report.

What Owners Expect for Their Money

Every business - regardless of how big it is and whether it's publicly- or privately-owned - has owners; no business can get all the financing it needs just by borrowing. An
owner
is someone who:

Invested money in the business when it originally raised capital from its owners - or, who bought ownership shares from one of the existing owners of the business.

Expects the business to earn profit on the owners' capital and expects to share in that profit by receiving cash distributions from profit and by benefiting from increases in the value of the ownership shares - with no guarantee of either.

Directly participates in the management of the business or hires others to manage the business - in smaller businesses an owner may be one of the managers or may sit on the board of directors of the business, but in very large businesses you are just one of thousands of owners who elect a representative board of directors to oversee the managers of the business and to protect the interests of the owners.

Receives a proportionate share of the proceeds if the business is sold or if the business sells off its assets.

Takes risks and may lose the amount of their shareholding.

When owners invest money in a business, the accountant records the amount of money received as an increase in the company's
cash
account (note the account is not called ‘money'). And, to keep things in balance, the amount invested in the business is recorded as an increase in an
owners' equity
account. (This is one example of
double entry accounting
, which is explained in Chapter 2.) Owners' equity also increases when a business makes profit. Because of the two different reasons for increases, the owners' equity of a business is divided into two separate accounts:

Share capital (also referred to as Invested capital):
Represents the amounts of money that owners have invested in the business, which could have been many years ago. Owners may invest additional capital from time to time, but generally speaking they cannot be forced to put additional money in a business.