Business owners need to be intimately familiar with various aspects of their company, especially financials. While there’s a myriad of crucial information that every business owner should know, like how to build business credit, their target market, and so forth — accounting knowledge is crucial. It’s no secret that you need more money coming in the door than going out, which means understanding the difference between profit and profitability
Both of these factors are important indicators of success, and measuring them effectively and accurately plays a crucial role in operational efficiency.
A Quick Look
When it comes down to understanding your business’s nuances and intricacies, both profit and profitability play their part. It’s easy to get these two seemingly synonymous terms mixed up, but business owners should understand their unique position. Let’s take a brief look.
Profit refers to the amount that remains after all business expenses have been deducted from your revenue. Your income statements give you the best look at overall business gains (profits).
Profitability, on the other hand, can refer to a wide range of percentages or decibels in the form of profitability ratios. It’s a measure of business success and isn’t necessarily a concrete number.
Diving Deeper Into Profit & Profitability
Knowing the definitions will only go so far, which means we need to dive deeper into the understandings surrounding profit and profitability. Here, we’ll go over each of these measurements in detail and provide you with the basic knowledge you need to push your business forward.
Profit is fairly straightforward; if you have leftover cash flow after your expenses — you net profit. If you don’t have money left over, you’re in the negative. It’s a simple equation you can utilize when looking at your income statement.
Profit = Total Revenue – Total Expenses
Here’s what it would look like in practice. Say you have $50,000 in revenue this month and $25,000 in expenses. Your overall profit would be $25,000. This number can be used for a wide range of operational needs, such as new hires, financing opportunities, expansion, etc.
If you take a trip down to the bottom line of your income statement, you’ll see either a positive or negative figure. Now, depending on your overall goals, the amount you’re up to could be a good thing or need some adjusting to reach your objective. If it’s negative, there are certainly some areas to improve. It could be that the strategy you’ve utilized to incur income isn’t up to par — or perhaps you need to cut down on expenses that are hurting your bottom line.
Now, the most important piece of the profit puzzle is understanding that profit doesn’t equal success. While you may have positive profits that seem high on the surface, they don’t indicate your profitability.
While profit can help you see glaring holes in your operational expenses or overall revenue, it doesn’t do the best job of showing you sustainability and growth. However, profitability is a method for measuring your profit so that you can have a better overall assessment of your company’s health.
There are three primary profitability ratios that business owners can rely on when calculating their company’s success.
- Profit Margin Ratio
- Return on Investment (ROI) Ratio
- Gross Margin Ratio
Profit Margin Ratio
A profit margin ratio sheds light on how much your business earns after deducting expenses. Sounds familiar, right? Well, the primary difference is that profit margins are measured as a percentage or a ratio.
It’s a way to see the percentage of each dollar earned is actually retained by the business. The formula for profit margin ratio is:
Profit Margin = (Revenue – Expenses) / Revenue
Using our first example of $50,000 in profits and $25,000 in expenses, the equation would look like: (50,000 – $25,000/$25,000) = 1.5
This means that you have a profit margin of 50% or .5 profitability and net fifty cents for each dollar. For many business owners, a profit margin that exceeds 25% is considered good.
More commonly known as ROI, return on investment refers to your business’s profitability compared to how much you spent on investments in the business itself. This could be marketing campaigns, new hires, or even debt financing options that could work for your business. As a business owner, you invest in various aspects of the company with growth and objectives in mind — an ROI ratio shows you how successful your specific efforts are.
The ROI formula is:
ROI = (Profit from investment – Investment Cost) / Investment Cost
Let’s say you run a YouTube advertising campaign in which you invest $100. From that campaign, you gain $150 in sales.
($150 – $100) / $100 = .5.
This means you have an ROI of 40% or $.40 for every dollar you put into the campaign—the higher the ROI, the better the profitability.
Gross Margin Ratio
The final entry on the list of profitability ratios is the gross margin ratio, which shows you how much more your products cost compared to what you bought them for.
This is an especially important measure of profitability for a wide range of businesses. After you calculate the cost of goods sold (COGS), you can utilize this formula to see your gross margin ratio. Here’s how to calculate:
Gross Margin Ratio = (Revenue -COGS) / Revenue
If you have that same $50,000 in revenue and $40,000 in COGS, here’s what it would look like.
($50,000-$40,000) / $50,000 = .2
This means that your gross margin ratio is 20% or .2 — and that after paying for your cost of goods sold, you have 20% of your revenue left over.
Start Measuring Your Profitability
While profit can help give you a peek at your business’s success, profitability paints a much more vivid picture of areas you could improve or pivot efforts. If you’re looking to pinpoint an issue or determine where you could improve — figuring out the right profitability ratio is the right first step. There are certainly unexpected hurdles to overcome, but the more business owners understand their profitability, the more prepared they can be. Even still, in cases where emergency business loans are the only way out — these ratios can even showcase the risks associated with certain funding solutions.
Use these formulas to help make decisions, plan for the future, shift business endeavors, and bring transparency to your financials. Profit is simple enough, but profitability shows you insights that matter in determining the true health of your business.