When two or more people come together to start a business, then it is called a partnership. The money invested by them is called capital invested and typically partners share their profits / losses in the ratio of the capital invested.
Sometimes, if one or more partners are looking after the day to day activities of the business and others are restricted to only making investments, then the active partners are called managing partners or working partners and partners who are not active are called sleeping partners.
Sharing of profits in a partnership
Most of the problems involving profit sharing can be fitted into one of the following cases.
All partners are working partners (unless stated otherwise, always assume that all partners are working) and invest their capital for an equal time period in the business. In this case, profits or losses will be shared in the same ratio of their invested capital. For example, let us assume that A, B and C come together to form a partnership, and they had invested C1, C2 and C3 respectively when they started the business. Now, when the business makes profit during its operations, the profits will be shared in the ratio C1:C2:C3.
Note: The time period for the investment is the same in this case.
Partners invest capital for different periods of time and all partners are working. In this case, it is not fair to share the profits in the ratio of their invested capital because the person who has locked his funds in a business for a longer period of time is bound to get more compensation for the opportunity he lost. Hence, the profits will be divided in the ratios of the products of their capital invested and the time period for each partner. For example, let us assume that A, B and C come together to form a partnership and they had invested C1, C2 and C3 respectively for a time period of T1, T2 and T3. Now when the business makes profits during its operations, the profits will be shared in the ratio C1T1:C2 T2:C3 T3.
The partnership firm has a mix of working partners and sleeping partners. There are two ways in which this problem can be handled.
- Working partners can be previously treated as regular employees of the company. In that case, they will draw a previously agreed upon salary depending on their contribution to the firm.
- Contribution of the working partners can be translated to share of profits. In that case, they will command an additional share of profits apart from the original share which they are entitled to based on their share of capital invested. For example, A and B come together to start a business. They invest equal capital to start with for equal periods of time. A is the managing partner and B is a sleeping partner. In this case, going by the ratio of their investments, their share of profits should be 50:50.
But, if they decide to compensate A’s additional effort by giving him an additional share of, say, 10% (which is to be mutually agreed upon) in profits, then the new profit share ratio will be 60:40.