Many people, who do not have enough knowledge of business, often get confused with Profit and profitability of the business. These terms may look alike but their meanings differ a lot.
What is profit?
In simple terms, profit of a business (often known as net profit or loss) can be defined as the money left out with the firm, after payment of expenses. In Financial terms, it can be calculated using the formula ‘Profit = Total Revenue – Total Expenses’. It gives us a numerical term. One can find the profit of a business by going through the income statement of that business.
What does profitability mean?
Profitability, on the other side, measures the business profit and determines the success or failure of the business. It does not give any specific and absolute numerical term. Instead, it tells what the profit of the business is, in terms of percentages or decimals. There are a number of profitability ratios in accounting which can be used to find out the success or failure of a business. For example, net profit ratio, gross profit ratio and return on investment ratio. While the profit is the difference between net revenue and net expenses, the profit margin can be found as a ratio between net income or profit and total sales.
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Importance of Profit margin /Profitability
To measure the success of a business, the mere use of profit cannot turn out to be a good tool. This is where the profitability or Profit Margins come into the picture.
For example, Company A spends $ 7,00,000 to sell $ 8,00,000 of products and services. The profit that the company will get will be $1,00,000. Second company, Company B, spends $3,00,000 to generate $4,00,000 to get the profit of $1,00,000. But, both the companies are not equally profitable even though they have the same profits. Company B is more profitable because it is spending less to generate the same profit. Company A is spending more to generate $1,00,000 in profit. that is why it is more vulnerable to any minor shift in the cost.
Clearly, from the above example, a quick look at the profit will not reveal that that which company is better. But if we use the profit margin, then a proper comparison can be made between the two companies. A has a profit of $1,00,000 dollars and generates $8,00,000. So the profitability will be 12.5%. Similarly, company B generates $1,00,000 in profit and has a total sale of $ 4,00,000. So the profitability shall be 25%. Clearly, company B is more profitable than company A.
Although these two terms are often used interchangeably their meanings are wide apart. While the profit tells you how much money you are left with after deducting expenses from revenue, profitability is used to find out whether the achieved profits are healthy or unhealthy. While making important investments, it is important that an investor takes a look at profit margins instead of making a decision solely based on profits of Companies. Precisely, profit margins provide a more realistic perspective of the companies by showing the long-term profitability of the business and its vulnerability to sudden changes in the fix costs. It is important to track down the profit margins of a company and develop effective plans to keep the profit margin as high as possible.
Also Read: Benefits of Account Reconciliation
There are two ways to increase the profit margin of the company.
1. Margin can be increased by increasing the price charged for the products and services. However, the price cannot be increased without making a proper analysis report of the impact of this change on customer behavior and sales.
2. A better and safe way to increase profit margins is to control the cost of the company. This requires a lot of effort by the company.
Thus, both the terms are important for any business but the profitability provides a deeper and long-term insight into the business. Moreover, it is important to have high profit margins.
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