Profitability

Profitability

What is profitability?

Profitability is the ability of a company to make a profit. Profitability occurs when the total income exceeds the total amount of expenses in a certain period. Suppose a company records its business transactions on an accrual basis. In that case, it’s possible that the terms of profitability won’t match the corresponding flows generated by search queries, since some accrual transactions (such as depreciation) don’t include cash flow.

Profitability can be achieved in the short term by selling assets that don’t decrease when profits decrease. However, this type of profitability isn’t sustainable. A company must have a business model that allows its current operations to be profitable, or it will eventually fail.

Profitability is one of the metrics that can be used to evaluate a business, usually as a multiplier of annual profitability. The best approach to value a company is using the multiples of annual cash flows, as this is better than the net cash flows expected by the buyer.

How to measure profitability

The net income and earnings per share ratios measure profitability. The net income ratio compares earnings after tax with revenue, while the earnings per share ratio represent a company’s profit divided by the outstanding shares of its common stock.

Example of profitability

To determine the value of an investment in a company, investors can’t rely solely on profit calculations. Instead, it’s necessary to analyze the company's profitability to understand whether it uses resources and capital efficiently.

If a company seems profitable but doesn’t have any profit, there are tools to increase the profitability and overall growth. Failed projects can quickly stall a company, leading directly to sunk costs. Companies can look at the profitability index to determine if a project is worth continuing in order to reduce the number of failed projects. It’s calculated by dividing the present value of future cash flows by the initial investment in the project. This ratio gives the company's management an idea of ​​the costs versus benefits of the project.

One of the first steps a company takes to increase profitability is to increase sales, which requires an increase in production. A company can also increase profitability with the help of the marginal returns theory. Marginal revenue, also known as marginal product, is a theory that states that adding workers up to a point increases the efficiency of using capital. Exceeding this number of workers leads to a decrease in returns and, ultimately, to a decrease in profitability. To be profitable, a company needs to apply this theory to its specific business, and production must grow efficiently and cost-effectively.

The difference between profitability and profit

While the two terms are used interchangeably, profit and profitability are not the same things. Both are accounting metrics of a company's financial success, but there are distinct differences.

Profit is an absolute number determined by the amount of income or revenue in excess of costs or expenses that a company incurs. It’s calculated as total income minus total expenses and is reported on the company's income statement. Regardless of the size or the scope of the business or the industry in which it operates, the goal of a company is always to make a profit. As for profitability, it’s the degree to which a business or activity yields profit or financial gain. As a result, although they sound the same, management and investors look at profit and profitability separately.

Changing the product mix and raising prices are the two approaches that most influence whether a company will make a profit or be able to make a profit in the future.

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2022-04-05 • Updated

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