Although the two terms are used interchangeably, profitability and profit are not the same. Both are accounting metrics that are used to analyze the financial success of a company, but there are distinct differences between the two. To adequately determine whether a company is financially sound or poised for growth, investors must first understand what differentiates a company’s profit from its profitability.
- Profitability and profit are metrics that are used to analyze the financial success of a company.
- Profitability refers to the extent to which a company earns a profit.
- Companies can determine profitability through a number of factors, such as expenses, demand, productivity, and competition.
- Profitability is commonly expressed as a ratio, such as the gross profit margin, net profit margin, operating margin, or EBITDA.
- While profitability is a concept, profit is an absolute amount, which means it is the total amount of income or revenue earned above any costs or expenses.
What Is Profitability?
Profitability is a measurement of efficiency. It is a metric that is used to determine the scope of a company's profit in relation to the size of the business and ultimately its success or failure.
Profitability can tell key stakeholders whether a company is able to sustain its position in the market and continue to grow. It is the extent to which a company earns a profit. There are two parts to a company's profitability: revenue and expenses. As such, a company is profitable if its revenue exceeds its expenses.
This metric is often expressed as a financial ratio to help management, analysts, and investors to better understand how the company is able to earn the money necessary to cover its expenses and other company-related costs. These ratios include profit margins and return on equity (ROE). Another key ratio is the earnings before interest, taxes, depreciation, and amortization (EBITDA). This ratio lets stakeholders know whether a company is financially healthy and how it can generate revenue.
Profitability can also be used to describe a business's ability to produce a return on an investment based on its resources in comparison with an alternative investment. To determine the worth of a company, investors cannot rely on a profit calculation alone. Instead, an analysis of a company’s profitability is necessary to understand if the company is efficiently utilizing its resources and its capital.
How Is Profitability Determined?
There are several factors that come into play when it comes to a company's profitability. Most of these can be shaped by the company and its management team while others may not necessarily be easy to control. We've highlighted some of the key determining factors of profitability below.
Costs can eat away at a company's profits. They can also spell the difference between being profitable or not. That's why it's important for companies to do their research. Conducting focus groups during the startup phase means companies will have the right idea of what kinds of products and services consumers want and ensures that products don't stay on the shelves for too long.
Consumer demand generates production. Knowing what consumers want and producing those products and services can help companies achieve profits. And the more companies sell, the more profitable they may become, especially if their sales outweigh their expenses.
Being more productive may help keep companies afloat. This doesn't mean you have to spend more to be more profitable. In fact, it could mean just the opposite. Companies can accomplish this by making improvements to and increasing manufacturing. For instance, companies may consider increasing their production goals and/or upgrading their production equipment and facilities.
This is one factor that companies may not be able to control. However, it's still a challenge they should be aware of and meet head-on. Businesses that operate in the same industry and provide similar products and services can eat away at each others' profits. This can decrease their profitability as well. Staying ahead of the competition, diversifying, and/or releasing new product lines can help boost profits and keep companies profitable.
As noted above, profitability is a measure that is commonly expressed as a ratio. These ratios can tell important stakeholders (managers, analysts, and investors) whether a company is able to earn income relative to its revenue, assets, and expenses.
The following are the most common profitability ratios used in the corporate world:
- Profit Margin: This ratio measures a company's profitability as a percentage of the total revenue it keeps as a profit. Put simply, the profit margin indicates the percentage of total sales a company keeps as a profit. Profit margins come in various forms, such as gross profit margin and net profit margin.
- Return on Assets (ROA): Return on assets expresses a company's profitability compared to its total assets. Put simply, it indicates how well a company can generate a profit relative to its asset base. To calculate ROA, divide the company's net income by its total assets.
- Return on Equity (ROE): This ratio tells stakeholders how profitable a company is based on its ability to generate a profit. A high return on equity indicates that a company's management is working efficiently by generating income and growth through its equity financing. ROE is calculated by dividing net income by shareholders' equity.
- EBITDA: This metric expresses a company's profitability based on a company's operations. It does not factor in expenses, such as interest, taxes, depreciation, and amortization.
Stakeholders can use profitability ratios to compare one company to others in the same industry. Companies with a higher profitability ratio are considered more profitable than comparable ones with lower ratios.
How to Increase Profitability
Companies often look for ways to increase their profitability. The following are just a few tips and tricks that management can use to help boost this very important metric.
- Cut the fat. This is as simple as identifying areas where there is excess business waste and making changes to eliminate them. For instance, updating outdated machinery—especially equipment that uses too much power—can be a great way to save on expenses and cut inefficiencies.
- Trust those who are loyal to the brand. Companies should focus on their existing customers. These are the clients who make regular purchases and even bring in new clients. Companies may want to upsell or cross-sell to these individuals.
- Look for new ventures and opportunities. This means that companies should consider moving into a new market or introducing a new product line to boost their profitability. This should only be done when it's feasible and after a lot of planning and research. Doing so can mean the difference between success and failure.
- Keeping track of costs. Taking note of the expenses each month is another way that allows businesses to locate costs that can be cut.
Profitability vs. Profit
As noted above, profitability is a metric used to determine the success or failure of a company. It is closely related to profit with one key difference. While profitability is a relative concept, profit is an absolute amount. As such, profit is determined by the amount of income or revenue above and beyond the costs or expenses a company incurs.
Profit is calculated as total revenue minus total expenses and appears on a company's income statement. No matter the size or scope of the business or the industry in which it operates, a company's objective is always to make a profit. Remember: a company can generate a profit but still remain unprofitable.
Although a company can realize a profit, this does not necessarily mean that the company is profitable. That's because the cost of running the business may be higher than the profit it generates.
What Are the Key Differences Between Profitability and Profit?
Profitability and profit are often confused as being the same but they are, in fact, different. Profitability is a financial metric that companies use to determine how successful they are. This is a relative measurement and is normally expressed as a ratio. Profit, on the other hand, is an absolute measurement. Put simply, it is a concrete figure that is expressed as a dollar amount. Keep in mind, though, that a company doesn't have to be profitable to earn a profit.
What Is a Profitability Ratio?
A profitability ratio is a type of financial metric that indicates whether a company is able to generate a profit compared to costs, expenses, or assets. It is typically expressed as a percentage. Examples of profitability ratios include gross profit margins, return on assets, return on equity, and EBITDA. The general rule is that a company does well compared to its competitors when they have a higher profitability ratio.
How Do Companies Generate Profits?
A profit is the amount of money that a company earns after all expenses are paid. Companies generate profits by keeping their expenses low and boosting their revenue. This can be done by hiring the right people, assessing business costs, identifying inefficiencies and cutting them out among other things.
The Bottom Line
Although they sound similar, profit and profitability are handled almost exclusively when it comes to investing and business management. Rearranging of product lines and increasing prices are two theories that hold the most sway over whether a company has a profit or can experience future profitability.