Profit vs. profitability
The company’s financial records will clearly state its income and its expenses of the company. When there is a higher income than expenses, the company makes a profit. This number is calculated on the income statement, and it is a crucial metric to keep track of. So, profit is a precise and directly computed number. Profitability in business is more relative. It is the ability of the company to generate a return on investment with its available resources when compared to another company or project. So, a company that is generating a profit may not be classified as profitable.
So, profit and profitability through similar, must not be confused with each other. The profit tells you how much the company has gained in terms of money after its expenses. Profitability is a measure of the success or failure of the business’s ability to make a good return on the money invested in it. It is not a specific amount of cash but uses different profitability ratios.
Definition of profit
Profit and profit margins are vital to a business. The profit is the amount of money that is left over from the revenue after the company has paid for its expenses. It is mathematically computed as the difference between the revenue and expenses and is found on the last line of the income statement. Hence it is called the ‘bottom line’. The profit made is essential for the company to keep itself in business and to have enough money to expand and grow without incurring debt. Profit keeps the business solvent. A company’s profit can be calculated from the cash flow statement and the income statement. The cash flow statement tells the reader how much money has come in and how much is going out in a particular time period. The difference between the two is the profit or the loss of the company.
Profit can be classified into three categories:
- Economic profit: This is the profit that calculates the opportunity costs. It is the potential profit that the company could generate by investing some money in a new project, new equipment, or a similar opportunity.
- Normal profit: This is the amount of money that the company needs to make a profit in order to sustain its operations. This includes the rent, salaries, and other regular expenses. It may also be called necessary profit. In case the company’s profit is less than the normal profit, it may be in danger of bankruptcy.
- Accounting profits: This profits improve the accounting books and factor in non-recurring items without the regular business expenses. This is not the same as economic profit.
Definition of profitability
Profitability in business measures how well the company is making returns on the investment of its owners or stakeholders. In a public company, the shareholders observe the profitability of a company to see if they are making a good return on investment (ROI). The profitability measures how well the company is using the resources that are available to it to make money. This includes the assets that it has, such as factories and equipment. The profitability of the company is not the same as the profit. Certain companies reinvest their profits back into the company to expand. So if they are making a profit but are not profitable, they are not serving the purposes of the owners’ and shareholders’ investments well. Profitability is very important in companies that are using capital or debt to grow their operations.
We can calculate and measure profitability using profitability ratios such as the return on assets (ROA) or profit margin ratio. This tells us the ratio of the company’s profit compared to the total costs such as equipment, inventory, and supplies. If the ROA is low it means that the company is making too little money compared to what is invested in it. It is not making the owners enough money for their investment, and this may result in fewer investors willing to put their money into the company.
The profit of the company can be the net profit or loss. This is because if there is leftover money after expenses, it is a net profit. But if the expenses are more than the revenues, it is a net loss. The formula for the profit of a business can be calculated from the numbers on the income statement. It is as follows:
Profit = Total Revenue – Total Expenses
This number is calculated and displayed on the bottom line of the income statement. A negative shows that it is making a loss and that corrective measures are called for in order to turn the company around.
We can take the example of a company that generated INR 22,000 in revenue in December and spent INR 12,000 on expenses. The profit would be the difference between INR 22,000 and INR 12,000, which amounts to INR 10,000. This is a positive number which indicates that the company made a net profit of INR 10,000. But, that profit does not indicate that the company itself is profitable. Profitability in business looks at the overall picture of the money that the company is making and compares it to the investment that was made in the company. The most popular profitability ratios that are used for this purpose are:
- Profit margin ratio
- Gross margin ratio
- Return on investment ratio
Profit margin ratio: This is the number that is the most similar to the profit calculation and tells you the difference in the expenses and profits called the profit margin. It is not a number but a percentage. The numbers used to calculate the profit margin ratio are usually found on the company’s income statement. The formula is:
Profit Margin = (Revenue – Expenses) / Revenue
If we use the same example as we did for profit, INR 22,000 is the revenue, and INR 12,000 is the expenses.
So, profit margin = (INR 22,000 – INR 12,000) / (INR 22,000) = 0.45
The profit margin is 0.45 or 45% which means that the company is making 45 paise for every rupee of revenue. A profit margin over 25% is good.
Gross margin ratio: The gross margin ratio compares the gross margin with the net sales. It helps understand how much higher you have priced your products compared to their cost price. So, it is the amount left when you subtract the COGS (Cost Of Goods Sold) from the revenue. The COGS is the amount that is spent to produce the goods sold. The gross margin ratio formula is:
Gross Margin Ratio = (Revenue – Cost of Goods Sold) / Revenue
So if the revenue is INR 22,000 and the cost of goods sold is INR 10,000, we calculate as follows:
Gross Margin Ratio = (INR 22,000 – INR 10,000) / INR 22,000 = 0.54
So the gross margin ratio is 0.33 or 33%. This indicates that the company has 33% of the revue left after spending on expenses.
Return on investment (ROI) ratio: this is the profit of the business compared to the amount of money invested in the business. It tells you your return on investment and is of particular interest to shareholders.
The formula for ROI is:
Return on Investment = (Gain from Investment – Cost of Investment) / Cost of Investment
Let us say that INR 1,000 is spent to market a product that generates INR 1,500 in sales.
ROI= (INR 1,500 – INR 1,000) / INR 1,000 = 0.5
So, the return on the investment of every INR 1 is returning 50 paise. The higher the resulting percentage, the better the profitability of the company.
The difference between profitability and profit
Profit and profitability are not the same in accounting. A company can generate profit and not be profitable. So, the difference between the two should be well understood. Profit is the amount that the company has left over after paying the expenses. Profitability is how well the company is using the resources that it has in hand to generate revenues. It tells the shareholders how much return the company is giving them for their investment.
How to use profitability and profit
The profit a company makes is the difference between the revenue and expenses of the company. A company can make a profit but how profitable it is, depends on comparing its profits to the resources that were used to generate the revenues. The owners and the shareholders of the company put money into the enterprise with the hope that it will give them returns on their money. So the profitability in business gives an indication of whether the company is delivering on this or failing at it.
Investors look for high profitability companies to invest in. This is because these companies are using the money that they have in the form of resources to make the most money. The company that uses its human resources, machinery, and infrastructure to make the most money is a promising investment. When investors compare a highly profitable company to one that is just breaking even, the profitable company is more attractive. Profitability is a reliable measure of a company’s performance regardless of its size and scale.
Is profitability a better measurement than profit?
Profit is the short-term status of the company’s bottom line. It is the short-term income status of the company. Profitability, on the other hand, is a more important long-term metric that is of interest to investors. While the profit calculation gives an indication of the bottom line, the profitability is the measure of the return on investment of the company.
A profitable company is very attractive to investors because the company is making the maximum use of its resources to generate more money. A profitable company will easily attract more new investors to help fund its further expansion and growth. Higher profitability shows the company is more likely to continue keeping the stock and dividend value high. Sustained performance and profitability is more important to investors than profits in the short term.
What is a good profitability ratio?
The ratio of the company’s profits over the investments made in it is the profitability ratio. If the ratio is high, it means that the company is doing well. This ratio can be measured as the net profits divided by the total assets of the company. Most companies that are publicly listed declare their profitability ratios as this is of great interest to the investors. However, other smaller companies must also keep a watch on their profitability ratio.
Generally, a profitability ratio of more than 10% is good because it shows that the company is doing more than merely breaking even. The company is making the best of all the resources at its disposal and building a strong business foundation. Profitable companies usually reinvest their earnings in the company to fuel further expansion and growth.
Monitor your financials quickly and easily
Lenders and investors alike monitor the profitability of a company to determine if the company will be able to repay its debts. Calculating profitability is important for businesses. But smaller businesses and family-owned businesses may find it difficult to calculate their investments and assets accurately. TallyPrime helps you monitor your company’s performance instantly regardless of the company’s size. Keeping profitability in mind helps long-term planning and reinvestments in the company’s growth.
