A business must have a way to measure its profitability. Profitability is a business’s profit relative to its expenses. A more efficient business will make more profit as a percentage of its expenses than a business that is less efficient. Profitability is one way to analyze a business’s financial statements and assess the business’s performance as a whole.
There are two key aspects of profitability which are revenues and expenses. Revenue refers to the income of the business. Income is the money earned through selling products or providing services. Expenses are resources that a business must pay for in order to stay open. These include things like employee payroll, rent, utilities, and other necessities. Profitability is the relationship between the revenues and expenses of a business.
It’s important to understand how to measure a business’s profitability. To do this, you will need to use ratios, which are the Return on Assets (ROA), Return on Equity (ROE), and Return on Capital Employed (ROCE). A business’s profitability is also listed on the business’s balance sheet and profit and loss account. These two reports can be used to measure the profitability of a company using the margin rations and return ratios.
What is Profitability?
Profitability refers to a business’s ability to generate a profit. Profitability is when a business’s revenue is greater than the number of expenses needed in a given accounting period. Profitability helps to determine and describe a business’s long-term success. It measures a business’s ability to generate income by using resources that it has available, such as people, time, and equipment.
When Does Profitability Arise?
Profitability arises when a business’s aggregate amount of revenue is greater than its aggregate amount of expenses. In other words, profitability arises when a business is able to make a profit and a profit is what is left over from income earned; after all, costs and expenses related to earning the income are deducted.
What are the Advantages of Profitability?
The table below shows the advantages of Profitability.
|
Advantages of Profitability |
| It provides you with information about how an investment changes the value of a firm. |
| It will take into consideration all cash flows from a project.
It will take the time value of the money into consideration in the calculation. |
| It considers the risks which are involved with future cash flows. |
| It will give you information about ranking projects while still rationing capital. |
| It is an investment tool that is easy to understand. |
What are the Disadvantages of Profitability?
The table below shows the Disadvantages of Profitability.
| Disadvantages of Profitability |
| The information generated is based on estimates instead of facts. |
| It may not provide the correct decision-making criteria for certain projects.
The tool ignores what is called the “sunk cost.” |
| It can be difficult to estimate opportunity costs. |
| It relies on optimism. |
What are the Key Aspects of Profitability?
Profitability has two key aspects which are income and expenses. Income also called revenue is the money that is earned from selling products or providing services. Resources are used by a company to generate income. Resources are used to produce the products that the company sells or to deliver the services. A business’s resources are used to settle expenses like salaries, utilities, and other necessities that could form part of the production process.
How to Measure a Company’s Profitability?
Profitability measures a business’s profit once expenses are deducted from the business’s revenue for an accounting period. A business’s profit can be found on the income statement, but profitability is not shown on the reports; instead, it uses the values on the reports to calculate profitability. The profit amount is used to calculate the profit margin or gross margin. The profitability ratio measures a company’s profitability, and its ability to make money from its operations.
The ratios listed below show how effective a company is in generating a profit.
- The gross profit ratio determines the relationship between gross profit and revenue from operations. The gross profit ratio shows the proportion of profits that products or services generate before selling and before administrative expenses. The gross profit ratio is calculated using the formula below:
Gross profit ratio= (gross profit/revenue from operations)x100
- The operating ratio highlights the relationship between operating costs and revenue from operations. These are a company’s operating expenses as a percentage of revenue. The formula below will calculate the operating ratio:
Operating ratio=(cost of revenue from operations + operating expenses / revenue from operations) x 100
- The operating profit ratio shows the percentage of profit a business produces from its operations, before subtracting taxes and other interest charges. The formula below will calculate the operating profit ratio:
Operating profit ratio = (operating profit / revenue from operations) x 100
Or
Operating profit ratio = net profit before tax + non-operating expense – non-operating income.
- The net profit ratio shows the relationship between net profit and net sales. It is used to measure the overall efficiency of a company. The formula below can calculate the net profit ratio:
Net profit ratio = (net profit / net sales) x 100
- Return on investment is the relationship between net income and investment. It can be used to determine if an investment can be profitable for a business. The formula below is used to calculate the net profit ratio.
Return on investment = (net investment gain / cost of investment) x 100
How do you Calculate Profitability on a Balance Sheet?
To calculate profitability on the balance sheet, follow these sets below.
- Add up all your income for the month.
- Add up all your expenses for the month.
- Calculate the difference by subtracting total expenses from total income.
- And the result is your profitability or any loss.
What Happens if a Business Isn’t Profitable?
As mentioned before, profitability is a business’s ability to make money. If a business is no longer profitable, it is losing money. The business may be losing money as a result of business operations that have an opposite effect on profits. A reduction in the market share from lower consumer demand or a downturn in the business may be forced to reduce operational output. If this is consistent and the business continues to lose money, it may force the business into bankruptcy.
How Do Firms Stay Profitable?
For a company to stay profitable it is important for the company to establish a strategic plan. This plan will help the company to plan ahead to identify new opportunities so that they can quickly deploy resources to seize those opportunities. This strategic plan can help the company conduct a financial stress test which will help them assess things like previous recessions that affected the company.
Another way a company can stay profitable is to grow its customer base. Top companies have a few things that they do consistently. First, they take a structured approach when growing their customer base. A customer strategy framework will help companies deepen their customer relationships through having a structure assessment tool that gauges what the customer may want from the company. Second, it is important that the company assess how they are going to meet its customers’ expectations and then implement those changes. These assessments should help a company get to know their customers better and, thus, be able to meet their customers’ particular needs.
Where does Profitability Appear on the Income Statement?
The income statement sometimes referred to as a profit and loss statement, provides information on how much a company has earned or lost. The amount of sales or revenue for a period is the amount from which all operating costs are deducted. The amount of sales or revenue for a particular period is the number from which all operating costs are deducted.
What is Profitability Analysis?
Profitability analysis is the analysis of the profitability of a business. Certain profitability ratios can provide insights into the profitability of a business. These ratios are the subset of financial indicators used to evaluate a business’s ability to create earnings. Profitability ratios can be used to evaluate how effectively a business uses its internal assets to generate revenue.
What is the Profitability Ratio?
Profitability ratios are financial metrics used to assess a business’s ability to generate earnings. Profitability ratios indicate how efficiently a company is generating profits and value for shareholders. There are two categories of profitability ratios and those are; margin rations and return ratios. Margin ratios give insight into a company’s ability to turn sales into a profit. Return ratios offer several ways to examine how well a company is generating returns.
Are Profit and Profitability the Same Thing?
No, there is a difference between profitability and profit. Profitability is the ability of a business to earn a profit. A business has a profit when revenue is left over from what a business generates after it pays all expenses directly related to the generation of the revenue, such as producing a product, and other expenses related to the conduct of the business’s activities. Profit is an absolute amount where profitability is regarded as a relative amount. Profitability measures efficiency and profit can be determined by deducting all expenses from the business’s revenue.
