Profit and profitability are two separate concepts. Here’s how they differ and how to start measuring.

Key takeaways:

• Profitability is a metric that tells you if your business is viable, and it’s a measurement used by investors
• Profit is the dollar amount of net earnings in a given period
• Measure profitability by assessing gross and net profit, operating profit, margin ratios, return on assets, and other calculations

Metrics keep your business running. Without visibility into performance, it’s impossible to know what areas need improvement, where the organization excels, and how things are likely to go in the future. Key performance indicators (KPIs) from sales to finance to HR tell you a lot about the state of the business, in the moment, and the past and future.

One of the most important metrics to determine the viability of your business is profitability. Many business owners use the terms profit and profitability interchangeably. But while they are related and both have to do with business accounting, there are key differences to be aware of when you’re starting to measure them. 

Here’s a deep dive into profitability, how it differs from net profit, and steps to take to measure this important metric.

What is profitability?

On a basic level, profitability tells you whether or not you are making money, or a profit. Positive profitability is, of course, one of the biggest goals of a business so that it stays viable and continues to grow.

What’s tricky about profitability, however, is that it goes beyond simply looking at a dollar amount at a given time. Properly measuring it requires looking at several metrics that analyze each aspect of the business and how each contributes to the organization’s overall success. 

Profitability measures a company’s ability to succeed or fail financially. It asks, is the business getting a return on investment? Is it efficient? Is it sustainable? Thus, profitability takes things a step further from just measuring profit.

Profit versus profitability

Even if a company sees a profit in a given month or quarter, it doesn’t necessarily mean that the business is profitable long term. Profit is a set number representing income minus expenses—the money left over after everything is paid. (Note that net profit could also be a net loss if profits are in the negative.)

While companies aim to make a tangible profit, profitability measures things relative to whether the scope of profit aligns with the size of the business and future concerns.

Both profit and profitability are taken into account to determine how a business is performing, but profitability is a deeper analysis of whether resources are being used correctly and if the model is sustainable. Profitability is a measure that investors use, for example, to determine a company’s worth.

How to measure profitability

So, how do you measure profitability? There are a few tactics you can use.

Let’s first look at the basic calculations to have on hand. You need to know your gross profit (net sales minus cost of goods or services sold); your operating profit (the sum of operating costs subtracted from gross profit); and your net profit (the sum of operating profit and income, minus additional expenses and taxes).

Margin or profitability ratios can tell you more about the company overall. You can convert the above metrics into ratios by taking the following steps:

• Gross profit margin ratio = (gross profit/sales) x 100
• Operating profit margin ratio = (operating income/sales) x 100
• Net profit margin ratio = (net income/sales) x 100

You can also measure the return on assets, which is a crucial step in determining profitability. It tells you the percentage of profit you’re making compared to your assets, or valuable property. To find this number and a return on investment, perform these calculations:

• Return on assets = (net income before taxes/assets) x 100
• Return on investment = net profit before tax/net worth

Next, assess your profit per client. This helps measure how valuable each customer is and what the averages are. Here are a couple of formulas to help you figure it out:

• Gross profit per project = total project fees – project expenses
• Hourly wage = gross profit per project/hours spent

Your goal should be to increase that hourly wage.

These tactics can help you get an overall sense of the viability of the business, which is essentially its profitability. While related to net profit, these metrics tell a bigger story of success or failure rather than the monetary amounts in the period you’re measuring.

Where to turn when you have business strategy or tax questions

The good news is that there are concrete steps any business can take to increase profitability and grow. When you need assistance streamlining your organization, work with the team at Provident CPA and Business Advisors. We are a team of experienced professionals who helps businesses just like yours create better strategies for long-term success and growth.

Contact Provident today to get started.

Capital expenses are large purchases required to keep a business growing. Here’s what you need to know about these costs, including the tax implications. 

Key takeaways:

• Capital expenditures are long-term investments like technology upgrades or significant equipment purchases
• These purchases are recorded on the balance sheet since they’re investments, not everyday operational costs
• Capital expenditures are not directly taxable, but depreciation can be deducted each year over the asset’s useful life
• Tracking these purchases helps a business understand returns on investment and how they relate to business growth

Part of running a business is taking all the right steps to record financial transactions and keep track of cash flow, tax impacts, and ROI. Some aspects of bookkeeping will be straightforward, like tracking the everyday costs of running the business. In contrast, others can be more complicated, like major equipment purchases that are investments into future growth.

This guide will walk you through what capital expenditures are and how they work when maintaining financial records and paying taxes.

What are capital expenditures?

Capital expenditures include the purchases made by a business on long-term physical assets and property that improve capacity or efficiency. These assets could be real estate, equipment, machinery, technology, and the like. In accounting, an expense is considered a capital expenditure if its life is more than one accounting period (one year) or if the asset improves upon an existing asset, like an efficiency upgrade to a building, for example. 

These expenditures are usually made for business projects or investments that support the business so that it can continue its operations, improve the way it delivers services, or continue growing its revenue. Generally, capital expenditures are costs to maintain a business’s operations or expenses that lead to future growth.

Sometimes capital expenditures need to be made on a fixed asset, which may include upgrading a machine or improving something about the business’s property. These payments are more like investments instead of regular expenditures. In other words, capital expenditures are expenses that the company capitalizes, whereas operating expenses are short-term costs that support day-to-day operations.

Note that expenses associated with normal, everyday repairs and maintenance on assets are usually not considered capital expenditures.

How are capital expenditures recorded?

To fully understand capital expenditures, you also need to learn how to record them on your financial documents. Best practice states that if a piece of equipment or other asset has a useful life for under a year, it’s expensed on the income statement and is not considered a capital expenditure. A true capital expenditure is recorded on the balance sheet and is regarded as an investment, something that leads to long-term business health and growth. 

After a large asset is purchased and incorporated into your workflows, it will depreciate for the rest of its life. Depreciation expenses are recorded on the income statement.

Capital expenditures and taxes

Unlike operational expenses, capital expenditures usually aren’t fully tax-deductible in the year the purchase was made. Instead, the depreciation they experience can be deducted over the life of an asset.

For example, if you purchase business equipment that costs $500,000 and will last five years, you may be able to deduct $100,000 in depreciation each year of its useful life. Like other business deductions, depreciation can reduce a business’s tax burden significantly. 

There are exceptions to this rule, however. For example, IRS Section 179 allows businesses to fully deduct the expense of some qualifying capital expenditures in the year they are purchased.

Why are capital expenditures important?

Businesses record financial information for a variety of purposes, from forecasting to presenting to investors to assessing current profits. Keeping track of capital expenditures also has a vital role in the overall financial health of a company. These purchases usually have significant impacts on the organization’s future and can also affect current cash flow, as they are expensive. While they require large upfront expenditures, they are meant to have long-term benefits and payoff.

Capital expenditures are notably crucial for businesses in industries like telecom and manufacturing. These types of organizations usually put a lot more investment into expensive equipment to see bigger payoffs. But a variety of small businesses also routinely make significant purchases that qualify.

Recording these payments helps a business track how much it is investing in improvements or new assets linked to growth.

Capital expenditure challenges to be aware of

The process of recording this kind of spending and correctly forecasting its impact on the business isn’t always as straightforward as you might like. These expenses are larger and often more complex than other costs. Thus, the accounting process surrounding capital expenditures takes a bit more effort and planning.

Another challenge is accurately predicting investment outcomes. While any capital investment should bring financial benefits, sometimes losses are incurred when unforeseen circumstances arise, whether something goes wrong with an asset or a problem arises that’s unrelated to the expense but impacts its use nonetheless. There is always at least a little uncertainty about the future when making capital expenditures, and all businesses can do is project the impact and outcome to justify the purchase.

Provident CPA and Business Advisors can help

Our team of experts helps businesses like yours get on the right track for long-term success. We can help you understand best practices for accounting and business planning so that you have the visibility and knowledge necessary to succeed.

Contact our team of business strategy and accounting professionals today to get on top of capital expenditure reporting and your business’s tax obligations.