How to Measure Profitability vs Profit in a Business

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.

A Basic Guide to the Roth IRA: Tax Pros and Cons

The Roth IRA is a tax-advantageous option for retirement savings. Learn how it works and who should use it.

Key takeaways:

  • Pros:
    • Tax-free withdrawals.
    • Withdraw contributions for any reason at any time without paying tax.
    • Money grows tax-free.
    • Make contributions at any age.
    • No income limits on conversions.
    • Lots of investment options.
    • No required minimum distributions.
  • Cons:
    • No upfront tax benefit.
    • Big tax bill if converting a lot of funds.
    • No tax benefit if your tax rate is lower in the future.
    • Must wait five years to start taking tax-free withdrawals.
    • Maximum contribution of $6,000 is pretty low.
    • Can’t contribute if you are married, filing separately, and make $10,000 or more.

Individual retirement accounts (IRAs) are savings plans provided by banks and other financial institutions that give you a few tax benefits. They’re easy to set up and maintain, so they’re one of the most popular retirement savings options. There are a few types of IRAs, including traditional, Roth, SEP, and SIMPLE. Depending on your situation and goals, there are pros and cons to each of these retirement accounts

Let’s take a closer look at one of the most popular types of IRAs: the Roth IRA. Here is your guide to what it is, the pros and cons, and who might benefit the most from this approach.

What is a Roth IRA?

A Roth IRA is a retirement savings option for individuals, similar to a traditional IRA except for how it’s taxed. These accounts allow you to take tax-free withdrawals when you’re in retirement and receiving the income. This is a big benefit since you don’t have to worry about paying income tax when you could be in a higher tax bracket, relieving a significant financial burden. 

This setup means, however, that the contributions you make now are already taxed, as they’re not tax-deductible like with a traditional IRA. Traditional IRA contributions are usually made with pretax dollars, and you have to pay taxes on the income when you withdraw it in retirement. 

Contributions to a Roth IRA can come from regular contributions, spousal IRA contributions, conversions, rollovers, or transfers. You cannot contribute anything but cash (earned income), so no securities or other assets qualify.

The pros and cons of Roth IRAs

First, let’s review the pros of Roth IRAs:

  • You get tax-free withdrawals.
  • Withdraw contributions for any reason at any time without paying tax.
  • All the money invested in the Roth IRA grows tax-free.
  • You can make contributions at any age when you’re earning income.
  • You can convert a traditional IRA into a Roth IRA with no income limits.
  • You have many investment options, including money market, CDs, mutual funds, stocks, bonds, or ETFs.
  • There are no required minimum distributions in retirement.

Next, the cons:

  • There is no upfront tax benefit—contributions are made with income that has already been taxed.
  • If you have a lot of funds to convert to a Roth IRA, you’ll have a pretty hefty tax bill the year you convert.
  • If your tax rate is lower in the future, you don’t see a significant tax benefit.
  • You have to wait five years to start taking tax-free withdrawals.
  • The maximum annual contribution of $6,000 is pretty low.
  • You can’t contribute if you are married, filing separately, and make $10,000 or more.

To that last point: something many married couples overlook is that you can’t contribute to a Roth IRA if you make over $10,000 and you are married filing separately. If you earned less than $10,000 and lived with your spouse during the applicable tax year, you can contribute a reduced amount. But, it still may make sense to go with a different retirement plan.

Carefully weigh these pros and cons to understand if a Roth IRA is best for you. Compare this type of account with a traditional IRA or a 401(k), both funded with pretax dollars.

Who should use a Roth IRA?

You should consider opening a Roth IRA if you expect to be in a higher tax bracket when you’re in retirement than you’re in now. This means that you’ll ultimately pay less in taxes on the income. Some people also decide to go this route just so they won’t have to worry about paying taxes later, whatever their situation may be. A Roth IRA helps you be proactive about a tax-free future.

Also, it’s important to note that you can’t contribute to a Roth IRA if you make over $140,000 if a single filer and $208,000 for joint filers. So, if you’re above these limits, unfortunately, you have to consider another option.

As touched upon above, there are limits on what you can contribute each year, too. For 2021, the limit is $6,000 if you’re under 50 and $7,000 for taxpayers older than 50. So, if you plan on saving more than these amounts each year, the Roth IRA may not be for you. Or, you’ll need to combine this investment with another retirement plan. (In comparison, a 401(k) allows you to contribute up to $19,500 for 2021).

Getting help from the experts

A Roth IRA can be a very wise choice for many who meet the income requirements and who want to take advantage of tax-free withdrawals in retirement. However, carefully consider all your options.

When you have tax-related questions, contact the team at Provident CPA and Business Advisors. We help you plan to pay the least amount of taxes legally possible. 

Reach out to Provident CPA and Business Advisors today.

What Is a Capital Expenditure and What Are the Tax Implications?

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.

8 Quick Tips for Better Business Cash Flow

How can you find the right balance for optimized cash flow? Start with these eight tips.

Key takeaways:

8 tips for better cash flow:

  • Maintain visibility
  • Be prompt with payments and invoices
  • Be on the lookout for changes
  • Try renegotiating
  • Reevaluate your invoicing practices
  • Cut unnecessary costs
  • Use accounting software
  • Consider a line of credit

Cash flow management continues to be a sore spot for many business owners. And failing to monitor and optimize cash flow can lead to big problems, now and in the future. These considerations are especially important after the economic downturn over the last year, with business closures, layoffs, remote work, and other severe business impacts. 

Cash flow describes the funds being transferred in and out of your business: the rhythmic movement of money. It measures all your income and expenses over a given period and tells you if you have any profit left over. Cash flow management is a crucial component of managing your business and ensuring it is stable and prosperous.

Fortunately, you can get on top of any issues with the right solutions. Here are eight quick tips for optimized cash flow:

1. Maintain visibility

The first step toward better cash flow is staying on top of it. You should always know everything coming in and out—all sources of income and all business expenses. This is an ongoing process that needs regular attention, so put a simple yet thorough process in place that works for you and your team, whether it’s using an online platform or just a spreadsheet. Create a budget and monitor for any issues you come across when sticking to it.

2. Be prompt with payments and invoices

It’s easy to become annoyed with clients when they’re dragging their feet on payment. Try tightening your payment terms, but also remember that you should send your invoices as soon as services are complete. Encourage promptness in the payment process by being prompt yourself. Don’t wait to pay your own bills, either, as this can create a dangerous cycle, and you can quickly get behind.

3. Be on the lookout for potential changes

Once you start tracking and monitoring cash flow regularly, you’ll get a sense of when something might change, even if numbers aren’t your strong suit. There will always be ups and downs we can’t predict, but still many we can. So pay attention to the market and do your research. For example, start tracking which seasons are great for your business and which may cause a cash flow crunch and plan accordingly.

4. Try renegotiating

Take a look at current contracts and see if you can renegotiate with your vendors. Are you getting the best deal? Are you paying a fair price for your business rental? Are there other service providers you could work with instead that are more affordable? Try leveraging whatever you can to get a better deal or rate. This may include negotiating better terms with long-term vendors based on an excellent payment history and consistent business.

5. Reevaluate invoicing practices

The reason payments aren’t coming through fast enough could be because of your workflows, not necessarily your payment terms. How long does it take for you to generate and send an invoice? Try using digital tools that make it much faster to perform these tasks. Make sure you don’t have a pile of invoices somewhere waiting to be sent or processed.

6. Cut unnecessary costs

Always be on the lookout for places to cut back, especially if you see worrisome patterns in your cash flow. It may be time to let go of a space you’re paying rent for but not using, for example, especially if you work primarily remotely now. Many subscriptions are started and rarely, if ever, used. Go through all of the expenses to see if there’s anything that’s just not worth the payment anymore, like software or professional services. Cut back wherever possible. 

7. Use accounting software

Staying on top of cash flow requires regular monitoring, organization, and some math. To make this process easier, try using an accounting software platform that tracks business transactions, generates reports, sends invoices at the press of a button, and helps make predictions for the future. The software can save you time, ensure accuracy, and increase visibility regularly. When a process is simpler, you’re more likely to do it.

8. Consider a line of credit

Finally, consider getting a line of business credit. Even if you’re not doing poorly right now, credit can protect you in the future if you have a cash flow problem. Many small businesses decide to do this long before they need it, just so they have peace of mind moving forward. 

Work with a business advisor

When you find you’re having a cash flow issue, another option is working with a business advisor who can help identify problems and put better practices in place. Talking to a professional is a good idea, even if you haven’t hit a roadblock yet. Asking for guidance now helps ensure you’ll stay on the path to long-term success. 

The team at Provident CPA and Business Advisors helps businesses grow profitably through a better business strategy. We also specialize in minimizing taxes for business owners and walking our clients through the best tax planning strategies.

Contact the team at Provident CPA and Business Advisors to learn more.