What do firms do with profit?

Profit is the net difference between revenue and costs. The main way that firms use profit is to:

  • Pay dividends to shareholders.
  • Invest in increasing capacity or expanding into new markets.
  • Invest in research and development.
  • Pay for new advertising and marketing strategies.
  • Save profit as part of cash reserves, to use as savings.
  • Tax. A government levy a corporation tax on the percentage of firm profits. (e.g. UK 20%)

Dividends

For public limited companies, shares are listed on the stock market. Investors will buy shares in part to gain annual dividend payments. If profit and dividends fall, then investors may sell their shares, making firm more vulnerable to take over. Increasing dividends is a way to make shares more attractive. If firms increase profit, they are likely to increase dividends. For limited companies, the shareholders are only a small number, but it is a way to gain more income from their business.

  • It might depend on the type of company. If a company is fast-growing and seeking to expand into new markets, (e.g. Amazon) then it may hold back from paying dividends and invest in more research and development. If the firm is well established, e.g. Electricity utility, it may concentrate on paying more dividends.

Research and development

Firms may wish to use profits to invest in developing new technologies which will enable the firm to increase productivity, efficiency and enable it to remain competitive over the long-term. For example, a car firm may invest in new equipment which enables it to automate the investment process. Without the investment in new technologies, firms may find they become uncompetitive and go out of business.

  • For industries, such as pharmaceuticals, investment in new drugs is particularly important. Because finding new drugs enables the firm to gain new sources of revenue in the future.

Develop new markets

Fast-changing technology can quickly transform industries. For example, in the mid-1990s, record companies were very profitable, with firms able to charge high prices for an album. The profit margin on CDs was quite high. However, within a few years, new sources of digital music had transformed the industry and many record shops went out of business and record labels found it harder to make profit. Therefore, firms need to be evaluating the industry and whether there is a threat to the current profit stream. If this is the case, they should try to diversify into new markets which offer a chance to benefit from the new technology. For example, traditional retailers who invested heavily in an online presence were successful in maintaining profitability over time.

  • For a company like water utilities, it may be harder to develop new markets and so they focus on investment and paying dividends.

Acquisition

Firms who are very profitable are in a position of being able to buy up other companies, who are potential competitors. This means that rather than trying to compete with other firms, they can benefit from their innovation and bring the best new products and trends into the firm. For example, Google has made several important acquisitions

  1. Android mobiles – This enabled Google to push its services onto the Android network of mobile
  2. Double Click – Double click was a potential competitor to Google Adsense. By purchasing Double-Click, Google could gain its knowledge and also remove a competitor.
  3. Youtube. Bought for $1.65 billion in 2006, Google has seen rapid growth in Youtube user engagement.

However, acquisition can be a risky business. Firms can become over-stretched and find they don’t have the expertise to manage new types of firms. For example in 2001, America Online (AOL) acquired Time Warner in a mega merger worth $165bn. The hope was that it would combine new tech (AOL) with old tech (Time Warner) but the new megalith firm couldn’t find synergies between the very different types of business and culture

Saving

Firms like Apple which are very profitable may struggle to even use their profit to the full. Rather than keep investing, they may just accumulate cash reserves until they can decide how to use it.

Cash reserves of major companies

According to Moody – a rating agency, US non-financial companies held a total of $1.7tn held on their balance sheets.

  • Apple’s cash reserves are the largest with total cash reserves of $216bn, 93% of which is overseas.
  • The top five companies Apple, Microsoft, Alphabet, Cisco and Oracle had a total of $504bn of cash by the end of 2015.
  • Microsoft has $90 billion of cash reserves – 91% overseas (Forbes)
  • Google’s $64.4 billion

Evaluation of how firms use profit

  • It depends on the business objectives of firms. Are they profit maximisers or seeking to maximise market share? If they are seeking to maximise long-term market share, they will be more willing to invest
  • It depends on the business climate. Is there fast-changing technology, which the firm needs to keep up with?
  • Are there viable options for business acquisition?
  • Can a firm avoid tax payments, though investment, acquisition or shifting money overseas?

Related

By on October 24th, 2019

One thought on “What do firms do with profit?

  1. Really a good article…it’s make to think more about to investment in equity share before analysing company financial statement….

Leave a Reply

Your email address will not be published. Required fields are marked *