THE DIFFERENCE BETWEEN PROFITABILITY AND PROFIT?
- Danish Khanna
- Dec 2, 2023
- 4 min read
Updated: Jul 24, 2024
While profits and profitability may seem like similar indicators for measuring business success, they are distinct metrics employed by bookkeepers to assess both current and future performance. Investors, moneylenders, and business owners rely on these numbers and percentages to make well-informed decisions.
It's essential to recognize that a business generating profits might still exhibit low profitability. Therefore, for entrepreneurs and investors, comprehending the difference between profit and profitability is crucial. This understanding offers a clear insight into the business's performance and provides precise information about its financial health. Bookkeeping companies leverage these two terms to evaluate the viability of a company.
1. WHAT IS PROFIT?
Also referred to as net income, profit represents the residual income of the business after subtracting all expenses. This figure is calculated by deducting the total expenses incurred by the business from its total revenue within a specific accounting period.
These expenses encompass the costs borne by the business to generate revenue during the defined period. Calculating net profit helps determine the surplus income remaining with the entity once all costs are accounted for.
It's important to note that certain accrued expenses, payable at a later date, are subtracted from the revenue to obtain an accurate net profit for the business. For instance, even though employee wages are typically paid in the first week of the following month, the cost of their labor is deducted from the current revenue to ensure accurate data. Bookkeepers compute net profit (profit = revenue – expenses) and report it at the bottom of the income statement, serving as a key indicator of the business's overall financial standing. If, for a given period, revenue is less than expenses, the bookkeeper characterizes it as a net loss in the income statement.
2. WHAT IS PROFITABILITY?
The distinction between profit and profitability lies in the nature of the metrics – profit being an absolute amount, whereas profitability is a relative measure often expressed as a percentage or in decimals. Bookkeepers leverage income and expenses to assess the profitability of an entity. Profitability analysis aims to determine if a business is generating sufficient profits to ensure sustained success in the future. It provides insights into the organization's efficiency and its return on investment.
The assessment of profitability serves to validate the business's capability to not only stay afloat but also to thrive over the years. Bookkeepers commonly use three key profitability ratios – profit margin, gross margin, and ROI ratio – to gauge the sustainability of the business. Engaging a professional bookkeeper is instrumental in monitoring these numbers and effectively managing finances. Utilizing advanced technology, they accurately determine this data, offering valuable assistance to entrepreneurs.
3. WHAT IS PROFIT MARGIN RATIO?
The profit margin ratio gauges the income a business generates after subtracting expenses. Although it resembles profit, the crucial difference lies in its presentation as a ratio or percentage, in contrast to profit, which is a specific numerical figure.
Bookkeepers apply the formula: Profitability = (Net Profit / Revenue) x 100 for computing the profit margin ratio. This computation provides the percentage of each dollar retained by the Melbourne-based business. For example, if a company earns $50,000 and incurs $30,000 in expenses during the same month, the resulting profitability ratio would be 20,000 / 50,000 x 100 = 40%.
This indicates that the business saves 40 cents of every dollar, with the remaining 60 cents allocated to expenses. A 40% profit margin ratio suggests a well-performing business with the capability to ensure its future sustainability.
4. WHAT IS GROSS MARGIN RATIO?
The gross margin ratio serves to compare the gross margin with the net sales, offering insights into the profitability of a business's products. Bookkeepers employ this ratio to gauge how competitively the products are priced relative to their cost.
This ratio enables an assessment of the revenue retained by the business after subtracting the cost of goods sold, encompassing expenses related to manufacturing and distribution. Bookkeepers use the formula: Gross Margin Ratio = (Revenue – Cost of Goods Sold) / Revenue x 100 to calculate this ratio.
5. WHAT IS RETURN ON INVESTMENT RATIO?
The third profitability ratio assesses the business's profitability relative to its investments, providing insights into the performance of these investments and the resulting return on investment (ROI).
Bookkeepers utilize the formula: Return on Investment = (Profit / Cost of Investment) x 100 for calculating this ratio. For instance, if a company invested $40,000 in a roadshow that generated sales worth $70,000, the ROI would be computed as (30,000 / 40,000) x 100 = 75%.
This percentage reflects the success of the campaign, indicating that for every dollar spent, the company earned an additional 75%. Bookkeepers may sometimes adjust the formula to account for taxes, enhancing the accuracy of the ROI calculation.
Hence, while the business may currently be turning a profit, its overall profitability could be limited. As a result, businesses often depend on their bookkeepers to monitor their financial performance, including the bottom line and profitability ratio, enabling them to make informed investment decisions.
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