What is profitability?
In business, profitability is the return on an investment . It is usually indicated by a percentage that links the net profit to the total investment in the business.
Profitability helps to show whether the bet on the business was worth it, since this index can be compared with profitability indicators for other investments, for example, financial. In other words, knowing the profitability of a business shows not only its ability to pay for itself, but also whether it would have been more advantageous to have left the money in the bank instead of opening the business .
How to calculate profitability?
To know the profitability of a company, it is necessary to divide its net profit by the total investment and then multiply the result by 100. The formula is as follows:
Profitability = net profit ÷ amount invested x 100
Net profit is the amount of revenue left after paying all bills, including vendors, employees, and taxes. The investment is the set of expenses that were made to put the company into operation.
For example, a businessman invested R$150 thousand to open a franchise. A month, he is managing to extract R $ 6,000 from the company. His monthly return on investment will be:
Profitability = 6,000 ÷ 150,000 x 100 = 4%
Analysis of rentability.
If he had left that money in the bank, the entrepreneur would hardly get an investment that would give him a monthly rate of return of 4%. Therefore, this indicator is at a level that can be considered interesting for a small company.
However, profitability alone cannot prove that the business is doing well. For this, it is important that the entrepreneur also monitor his profitability indicator. See below the difference between profitability and profitability.
What is profit?
Profitability, also called profit margin, is an indicator that shows the profit obtained by the company on sales made in a period.
The profitability index is also a percentage value and indicates the operating efficiency of the company, that is, if its operations pay the authorized costs and expenses.
How to calculate profit?
As in the calculation of profitability, the indicator of profitability is also related to net income. However, to reach profitability, it is necessary to divide this net profit not by investment, but by the gross income of the company, and then multiply it by 100, as shown in the formula:
Profitability = net profit ÷ total income x 100
As already mentioned, net profit is what gives the company the amount it received from its sales after paying all its obligations. Revenue is the value of the sales itself, before these discounts are applied.
Going back to the example of the franchise owner who has a net profit of R$6,000 in the month. Assuming that, in order to make this profit, he had to sell R$60,000 worth of products. The calculation of your profitability looks like this:
Profitability = 6,000 ÷ 60,000 x 100 = 10%
A company’s profit margin depends on its costs, the prices it charges, and the competition in its industry. That is, it is directly related to the way in which the company is positioned in the market.
Companies that sell a lot may have a lower profit margin. A seasonal business, such as a company that wants to take advantage of a fad or market trend, needs a large profit margin as it can be short-lived.
How to relate profitability to profitability.
To get an idea of whether the business is doing well, you need to look at the two indicators together. Analyzing only one of them can generate false impressions, both positive and negative.
A company that has high profitability may need to make adjustments if its profitability is low.
The business may be profitable compared to your initial investment. However, if your benefit is small compared to your income, it may mean you have very high costs. This company will be more vulnerable to changes in the market that affect its income, and may even have to go into debt to cover its monthly obligations.
On the other hand, a very profitable company can disguise a bad business if its profitability is low. The company may have a high profit margin, but sell a small amount compared to the size of the investment it needed to make. This means that you will have an excessively long recovery period.
What is the return period?
Return on investment, also called ROI , is directly related to profitability. It is the time that the entrepreneur must wait to recover the money he invested and begin to accumulate profits.
The return term formula is an inversion of the return formula. The recovery is calculated by dividing the value of the investment by the profit of a period:
Company profitability = Investment ÷ net profit
In the case of an entrepreneur who invested R$150 thousand and has a monthly profit of R$6,000, his recovery will be:
Company return = 150,000 ÷ 6,000 = 25 months
That is, the company will take 25 months to cover all the initial investment it received.
Other profitability indicators
The return on investment as explained here is also known by the acronym ROI, which comes from the English Return on Investment . However, there are other indices that allow a company’s profitability to be analyzed in a different way. For the calculation of these indicators, the values indicated in the annual accounting reports are generally used.
It shows how much the company sold for each dollar invested. That is, instead of earnings, this indicator relates income to the amount invested. It shows how efficiently the company uses its assets.
This ratio is not a percentage, but an absolute number that shows how much the company’s assets “converted” in a period. If the company is having a good turnover, it means that it is having a good volume of sales in relation to its initial investment.
Formula: Asset Turnover = Net Income ÷ Total Assets
Return on assets
Also called return on assets, this ratio calculates a company’s profitability based on how much its assets and rights are worth, regardless of where the resources to obtain them come from. It corresponds to the acronym ROA (Return On Assets) .
This indicator gives an idea of the company’s ability to capitalize and is typically used for year-over-year performance comparisons.
Formula: ROA = net profit ÷ total assets x 100
Return on equity
This indicator shows the profitability of the company considering only the capital invested by the partners. For example, loans that are still being paid do not enter the account.
The return on capital or ROE (Return On Equity, in English) shows the profitability of the company for shareholders.
Formula: ROE = net income ÷ equity x 100