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Financial Statement Analysis: A Practitioner's Guide, Fourth Edition by FERNANDO ALVAREZ, MARTIN FRIDSON

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Chapter 5

What Is Profit?

Profits hold an exalted place in the business world and in economic theory. The necessity of producing profits imposes order and discipline on business organizations. It fosters cost-reducing innovations, which in turn promote the efficient use of scarce resources. The profit motive also encourages savings and risk taking, two indispensable elements of economic development. Finally, profitability is a yardstick by which businesspeople can measure their achievements and justify their claims to compensation.

In view of all these essential economic functions, one might suppose that users of financial statements would have long since devised a universally agreed-upon definition of profit. This is the case, however, only at the following, extremely rudimentary level:

Unnumbered Display Equation

Defining profit in such a manner merely stirs up questions, however: What is revenue? Which costs count? Or, more precisely, which costs count now, and which count later? Because these questions can be answered in many different ways, countless definitions of profit are in common use. For analysts of financial statements, the most important distinction to understand is between bona fide profits and accounting profits.

BONA FIDE PROFITS VERSUS ACCOUNTING PROFITS

In defining bona fide profits, the simple formula, revenue minus costs, represents a useful starting point. When calculating this kind ...

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