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