Profitability is the ability of your business to earn a profit. A profit is what’s left of your generated revenue after you pay all your expenses, such as the ones involved in producing your product.
So how do you analyze profitability? You want to generate enough revenue to more than cover the expenses you incur. Let’s look at the primary analytical approaches:
- Net profit margin — Let’s say you have a net income of $100,000 and net sales of $1,000,000. Your profit margin would be 10%. This means that for every dollar you make in sales, you earn a dime in net income.
- Gross profit margin measures the cost of production — Let’s say you have a gross profit of $125,000 and a net sales profit of $3,750,000. Your gross profit margin would be 3%. This means that, of each dollar you make in sales, you spend a little over 97 cents to produce the product.
- Operating margin — This tells you how much profit you lose to costs unrelated to producing the product. Costs unrelated to production can include such things as general business, staff and administrative expenses. Net operating margin is often referred to as your earnings before interest and taxes or EBIT. Let’s say you have an operating profit of $90,000 and net sales of $1,000,000. Your operating margin is 9%, meaning you earn nine cents of every dollar you make in sales for business expenses not related to production.
- Return on assets measures how effectively and efficiently you are using your business assets to generate profit. If a business posts a net income of $10 million in current operations and owns $50 million worth of assets, it returns 20 cents in net profit per year. In other words, for every dollar of assets the company invests in, it returns 20 cents in net profits a year.
Although the terms profitability and profits are sometimes used interchangeably, they aren’t the same. What differentiates your company’s profit from its profitability?
- Profit is determined by the amount of income or revenue above and beyond the costs or expenses a company incurs. No matter the size or scope of the business you operate in, your objective is always to make a profit.
- Profitability measures the scope of your company’s profit in relation to the size of your business. A company that turns a profit, in absolute terms, may not be profitable in relative ones.
What can you do, then, to increase profitability and your company’s overall growth?
- When considering a new project, determine whether it is a project worth pursuing. Analyze for insight into its costs and benefits. Doing this consistently will reduce the occurrence of project failures. You can increase profitability by boosting sales, of course. This may mean you’ll have to increase production.
- You can increase the number of workers you employ or your use of capital. This can be dicey — you don’t want to exceed the number of workers so that it leads to diminishing returns, which, in turn, would mean less profitability.
- You may look to rearrange product lines or increase prices.
Without profitability, your business will not survive in the long run. Measuring current and past profitability and projecting future profitability is key. When you’re highly profitable, you can be rewarded with a large return on investment.
