Did you know that only 40% of small businesses are profitable? This means that only 40 out of 100 generate profits. The rest are breaking even with their expenses or losing money. However, a business’s profits aren’t the only indicator of profitability. Financial experts may deem a business to have low profitability even if it’s generating profits.
This may be confusing to you now but profits and profitability aren’t the same.
Although they’re both indicators of a company’s health, one has more weight than the other. Keep on reading to see their main differences and to see which value you should consider in order to have a more accurate idea of your business’s financial status.
What is Profit?
Profit is perhaps a more common term compared to profitability. This is because small businesses calculate their profit on a regular basis. Bigger businesses tend to calculate profit on a quarterly and annual basis.
A business’s profit refers to the money left over after you subtract your expenses from your total revenue. It can also be in the negative, which then indicates a loss. With that said, here’s a simple equation to illustrate it: Profit = Revenue – Expenses
Let’s set an example: your business earned a total of $15,000 in one month. For that month, your expenses, including inventory, bills, and staff salary, amounted to $10,000.
Following the equation above, your profit would then be $5,000. If, however, you only earned $5,000 for that month, you end up with a loss of $5,000.
What do profits say about a company’s health? Contrary to your expectations, profits are not a huge part of the picture. They’re not a good indicator of a company’s health, although it’s part of the equation.
Your company can have positive profits but still not be profitable.
What is Profitability?
While profit is an absolute number, profitability is a relative amount or in other words, a percentage. It refers to the ratio between profit and revenue. It measures the efficiency of a business or its ability to produce an ROI.
There are 3 equations that can illustrate the profitability of a business: profit margin, gross margin, and ROI ratios.
Profit Margin Ratio
The profit margin ratio shows how much you’ve earned in relation to your capital. With that said, here’s the equation: Profitability = Profit / Revenue * 100.
Let’s take 2 companies, both with a $10,000 profit.
Company A earned $50,000 in one month, and its expenses were $40,000.
Company B earned $20,000 with its expenses at $10,000.
Although the two have equal profits, they don’t have the same profitability. Following the equation above.
Company A’s profitability = ($10,000/$50,000) * 100, which is then equal to 20%.
Company B’s profitability = ($10,000/$20,000) * 100 = 50%.
With this example, we realize that a company’s profit isn’t a good indicator of its profitability. It’s clear that Company B is in better health than Company A. It can better utilize its resources and capital.
Profit margin ratio is an important profitability measurement because the company spending more is going to be more vulnerable to an increase in costs.
For example, Company A pays for $10,000 for shipping while B only pays $4,000. If shipping costs increase by 20%, which do you think will be more affected by the shift?
Company A’s expenses will then shoot to $42,000, bringing down their profits to $8,000. Company B’s expenses will only increase by $800, which means its profits are still high at $9,200.
Gross Margin Ratio
Gross margin ratio, on the other hand, measures your gross margin to your net sales. This shows the profitability of your goods.
We measure it using the formula: Gross Margin Ratio = (Revenue – Cost of Goods Sold) / Revenue * 100.
Let’s take Company C and Company D as examples this time.
Company C earned $10,000 from the sale of goods, which cost it $7,000.
Company D earned $15,000 from the sale of its goods, which cost it $12,000.
As you can see, they have the same profits this time around, right? However, let’s see if they have the same profitability.
Following the equation above, Company C’s gross margin ratio = ($10,000 – $7,000) / $10,000 * 100 = 30%.
Company D’s gross margin ratio = ($15,000 – $12,000) / $15,000 * 100 = 20%.
Here, we see that Company C has a higher markup on its goods. It’s earning more in relation to how much it bought the goods it sold.
You might also notice that gross margin ratio isn’t that much different to profit margin ratio. They have a key difference, though: gross margin ratio only takes into account the inventory. It doesn’t factor in the revenue from other services, and it doesn’t factor in other expenses, like bills.
Return on Investment (ROI) Ratio
The ROI ratio shows how profitable a company is in relation to the cost of its investments. Companies use it to compare the efficiency of their different investments.
They measure it using the formula: ROI = Profit / Cost of Investment * 100.
This formula can further expand to reflect different calculations. For example, a company may also subtract the taxes to arrive at a more accurate ROI.
Let’s say that a company spent $10,000 for a marketing campaign. It then resulted to $18,000 worth of sales. Its profit would then amount to $5,000.
In this case, the ROI would be = ($8,000 / $10,000) * 100 = 80%. This means that for each dollar you invested, you earned 80% more.
As we said above, the formula is flexible, so you can add items in the formula to get a more accurate look of your true ROI. In this case, for example, you may subtract the cost of goods to see the real percentage of your profits.
What Does This Tell Us?
With the explanation above, you’ll understand that the difference between profit and profitability is huge.
On top of calculating your profits, you must also measure your profitability to make sure that your company is using its resources in an efficient manner to generate the numbers you want to see. In summary, if you’re spending more, you should also be earning more.
If you have any questions about your company’s financial state, contact us today and see how we can help.
