Profitability is the ability of a company or business to generate revenue over and above its expenses. It is usually measured using ratios like gross profit margin, net profit margin EBITDA, etc. These ratios help analysts, shareholders, and stakeholders to analyze and measure the company’s ability to generate revenue.
The revenue earned is used to cover its operational cost, create value by adding assets to the balance sheet and analyze its ability to expand and take up projects for its future growth. The higher the ratio, the better it is because the company performs well. These ratios are often used to compare the performance of companies against each other.
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- Profitability refers to a company’s ability to generate revenue that exceeds its expenses. Ratios such as gross profit margin, net profit margin, and EBITDA are commonly used to assess profitability.
- Profitability analysis helps analysts, shareholders, and stakeholders evaluate the company’s capacity to generate revenue and cover operational costs.
- By adding value to the balance sheet and demonstrating the ability to undertake growth projects, profitability contributes to business growth.
- Analysts employ these ratios to make informed investment decisions, while banks assess creditworthiness and grant loans based on profitability ratios.
The financial term profitability is used to explain the concept of profit earning capacity of a business. It is the ability or an organization, a project or an investment opportunity to generate good profit over a specific period of time. The net profitability not only help the business cover its cost and expenses, but also leave extra funds that can be used for meeting daily financial needs or reinvested to earn further returns.
It is a metric that is widely used to assess or evaluate the financial health of the entity and its probability of success and expansion in the future, It gives an idea to the stakeholders how much it can sustain and grow and also provide for any unforeseen situations, if they arise.
Business owners and investment analystsInvestment AnalystsAn investment analyst is an individual or firm that excels in the financial and investment research and have a keen knowledge of financial instruments and models. Such financial professionals include portfolio managers, investment advisors, brokerage firms, mutual fund companies, investment banks, etc. use profitability to determine whether it’s wise to invest or not, considering its current and future growth. The business can sustain and meet the stakeholders’ demand only when it earns profit. However, it varies between business to business and between sectors.
Many external factors like market conditions, economic and political stability, consumer sentiments, etc., influence an organization’s profits. Therefore, apart from generating profits, the company should concentrate on risk management to maintain its net profitability.
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Video Explanation of Profitability Ratios
There are several formula or measures that are commonly used in the financial market to measure the business profitability. Let us go through them.
Gross Profit Margin – This can measure the percentage of revenue that is over and above the cost of goods sold (COGS). It is calculated by deducting the COGS from the revenue earned, and then the result is divided by the total revenue and multiplied by 100, to get the value as a percentage.
Gross Profit Margin = [(Total revenue – COGS)/ Total Revenue] x100
Operating Profit Margin – This shows the percentage of revenue that is left after subtracting both COGS and operating expenses. It gives and understanding regarding the efficiency level of the business in running and managing the daily operations.
Operating Profit Margin = [(Total revenue – COGS- Operating expense)/ Total Revenue] x100
Net Profit Margin = It represents the profit that is earned by the company after meeting all its expenses including interest and taxes. The formula is as follows:
Net Profit Margin = [(Total revenue – Total expense)]/ Total Revenue] x100
Return On Equity (ROE) – This metric evaluates the profit earning capacity of an organization in relation to the shareholder’s equity. The formula for the same is given below:
ROE = (Net Income/ Shareholder’s equity) x 100
Return On Investment (ROI) – In this metric, the gain or loss of an investment is compared to the cost of the investment and evaluate the profit earning capacity of the business.
ROI = [(Investment Gain – Cost)/Cost] x 100
Let us take an example of economic profitability.
- Sales = $50,000
- Purchase = $30,000
- Direct CostsDirect CostsDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects. = $500
- Rent = $1,000
- Salary = $3,000
- General Expenses = $1,500
- Depreciation = $500
- Interest Paid = $200
- Taxes @ 30% = $3,990
Profit = $ (50,000-30,000-500-1,000-3,000-1,500-500-200-3,990)
Profit = $9,310
Let us calculate the most commonly used ratios to calculate business profitability.
#1 – Gross Profit Margin
Gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold. is a ratio of gross profit to sales, which means the entity can recover its cost of production from the revenue it is earning. Therefore, the higher the percentage, the better it is.
As per the above example,
Calculation of gross profit will be: –
Gross Profit = Sales – Purchase – Direct Cost
Gross Profit = $(50,000-30,000-500)
Gross Profit = $19,500
Calculation of gross profit margin will be: –
Gross Profit Margin = Gross Profit / Sales
Gross Profit Margin = 19,500/50,000
Gross Profit Margin = 39%
#2 – Net Profit Margin
Net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization's overall profitability after incurring its interest and tax expenses. is a ratio of net profit to sales. Net profit is the profit earned after reducing operational costs, depreciation, and dividend from gross profit. A higher ratio/margin means the company is making well enough to cover all its costs and payout to its shareholders or reinvest its profit for growth.
Profitability = $9,310 / 50,000
Profitability = 18.62%.
As calculated above, the net profit margin is 18.62%.
#3 – Operation Profit Margin
Operating profit marginOperating Profit MarginOperating Profit Margin is the profitability ratio which is used to determine the percentage of the profit which the company generates from its operations before deducting the taxes and the interest and is calculated by dividing the operating profit of the company by its net sales. is a percentage of earnings to sales before interest expense and income taxes. A higher margin means companies are well equipped to pay for their fixed and operational costs. It also indicates efficient management and their ability to survive in economic downtime compared to their competitors.
As per the above example,
Calculation of operating profit will be: –
Operating Profit = Sales – Expenses excluding Interest and Taxes
Operating Profit = $(50,000-30,000-500-1,000-3,000-1,500-500)
Operating Profit = $13,500.
Calculation of operating profit margin will be: –
Operating Profit Margin = Operating Profit / Sales
Operating Profit Margin = 13,500/50,000
Operating Profit Margin =27%.
#4 – EBITDA
Its earnings before interest, tax, depreciation, and amortization. EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business's performance with that of its competitors. is commonly used to compare a company’s performance with others and is widely used in valuation and project financing.
As per the above example,
Calculation of EBITDA will be:-
EBITDA = Sales – Expenses (Excluding Interest, Tax, Depreciation, and Amortization)
EBITDA = $(50,000-30,000-500-1,000-3,000-1,500)
EBITDA = $14,000
Some of the advantages are as follows: –
- Profitability helps us determine the pricing of our products and services. In many cases, if any revision is required. Pricing is very important for any business, as it leads to increases in net revenueNet RevenueNet revenue refers to a company's sales realization acquired after deducting all the directly related selling expenses such as discount, return and other such costs from the gross sales revenue it generated.. Still, it also has to be at a comparable level with competitors. Therefore, it helps in pricing strategy.
- Higher economic profitability is directly related to higher sales. The various ratios and metrics used help compare past data and analyze if the company can survive in a downtime.
- It helps us in analyzing the return on investment from a business. That means how effectively the company issues its resources to generate value and profit. In addition, it lets us know if the resources are properly deployed and if they can sustain in the future.
Some of the disadvantages are as follows: –
- It does not accurately predict company performance in the future as companies often window dress their accounting statements.
- Cannot compare a company’s performance across different industries. For example, the analysis of comparing pharmaceuticals with the FMCGFMCGFast-moving consumer goods (FMCG) are non-durable consumer goods that sell like hotcakes as they usually come with a low price and high usability. Their examples include toothpaste, ready-to-make food, soap, cookie, notebook, chocolate, etc. industry would not be accurate.
Profitability ratios are key indicators to analyze the performance and liquidity of the company and are derived using income statements. It is also used to determine the strengths and weaknesses and how companies achieve profit from their operations. Analysts use ratios to decide whether or not it is a good proposal for investment purposes. Banking institutions often use such ratios to determine the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan. of a company and sanction loans based on such ratios. Among other ratios, profitability ratios are of utmost importance as all businesses ultimately focus on earning profit and creating value for their stakeholders.
Profitability Vs Revenue
Both the above are important financial metric for assessing the financial condition of the entity. However, there are some differences between them, as follows:
- The profitability percentage measures the ability of the business to earn profit which is the earning left after covering the costs, whereas the latter is money that the business earns its primary business activity.
- The former is a broader assessment of the financial health of the company compared to the latter.
- The former is the measurement after deducting all expenses, taxes and interest payable, whereas the latter is the measurement which show the sales value of the organization.
- A company may have high revenue levels but of its expenses and costs are too high, then the profitability percentage will come down.
- Business sometimes focuses a lot on increasing the revenue levels at the cost of profits, which is harmful is the long run.
- The former shows how efficiently and smoothly the company is able to run its operations. However, the latter shows how efficiently the business is able to sell its products and services.
- The former gives an idea about the financial condition of the business and the latter gives an idea about the quality of its products, services, customer satisfaction, market share, etc.
Frequently Asked Questions (FAQs)
The profitability metric is important because it allows businesses to assess their financial performance and determine their ability to generate profit. It helps evaluate the effectiveness of business strategies, make informed decisions, attract investors, and ensure long-term sustainability.
The profitability index, also known as the profitability ratio or profit index, is calculated by dividing the present value of future cash flows by the initial investment. It helps in evaluating the profitability of an investment project. A profitability index greater than 1 indicates a profitable project, while less than 1 signifies a project that may not be financially viable.
Profitability refers to a company’s ability to generate profit and financial returns. It focuses on short-term financial performance. On the other hand, sustainability encompasses a broader perspective, considering environmental, social, and governance factors. While profitability is important for business success, sustainability emphasizes long-term viability and responsible practices that consider the impact on society and the environment. Striking a balance between profitability and sustainability is crucial for businesses in today’s world.
This article is a guide to Profitability & its meaning. We explain its differences with revenue, along with formula, example, advantages & disadvantages. You can learn more about valuation from the following articles: –