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Profitability Definition in Simple Words:

Profitability serves as a measurement of efficiency, and a guide to further improvement. It is critical in determining a firm’s overall health, in terms of revenues and profits. It can be defined as the capacity to generate profit from all the aspects of a business; illustrating how proficient the management is in yielding revenue by employing available resources.

Measurement of Profitability

Profitability is measured by an “income statement” that maintains a record of income and expenses over an interval of time. Businesses cannot survive without profitability, and a highly profitable business rewards its owners with a considerable return on their investment.

Business managers are responsible for increasing a firm’s profitability, by subjecting each process under scrutiny, the aim is to point out changes that improve profitability. These changes can be examined with pro forma income statement, also referred to as, Partial Budget, allowing one to analyze the impact of these modifications on profitability, before implementing it.

Profitability Ratios:

Various Decision Tools or Profitability Ratios can be employed to evaluate an organization’s profitability. The following are some of the commonly used tools:

Profit Margin:

  • It is expressed in percentage and can be assessed by dividing net income by revenue. Net income or net profit is the remaining amount after subtracting company expenses from total revenue. Gross profit margin, pre-tax profit margin, net margin, operating margin are different kinds of profit margins commonly used during evaluation.

Though it is quite helpful in comparing the profitability of two different companies, it is necessary that both these organizations have to be from the same industry, containing similar business models and demonstrating the same revenue. A comparison otherwise would be inaccurate, and therefore, redundant.

In the case of companies that are losing money, the profit margin is inconsequential as they are not generating any profit.

Return on Assets:

Also known as Return on Investment (ROI), acts as an indicator of company profitability in relation to its total assets. It reveals how efficient the management is in employing resources to its full potential, to generate profit. ROA is denoted as a percentage and is calculated by dividing an organization’s annual earnings by its total assets.

In the case of public companies, ROA varies significantly as they are quite dependent on the industry. Therefore, ROA, when used to compare company profitability should be evaluated against past ROA numbers or ROA of an analogous company. Higher ROA is the preferable result as it denotes that the business is generating more revenue on less investment.

Return on Equity:

  • ROE is the ratio that assesses revenue generated by a company in relation to investments made by equity holders. It is also denoted as a percentage and measures a company’s efficiency, indicating its capacity to generate profit without much investment.

A higher ROE is a measurement of management efficiency when utilizing investment. One should be aware that decrease in value of shareholder’s equity, for instance, write-downs or share buy-backs, boosts ROE number mechanically. The same thing can be observed in cases of high debt. Therefore, to get accurate ROE, comparisons should be made within the same industry, and evaluation (high or low) should be achieved under the same context.

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