Different measures of profitability exist so a business owner or manager needs to know which of the profitability to watch.
What is profitability?
The profitability of a business is determined by how much money it makes compared to how much it spends. More effective businesses will make more money relative to their costs than less effective businesses, which must spend more to make the same amount of money.
The different measures of profitability
There are three different measures of profitability:
Commercial profitability – this measures the effectiveness of your price/volume strategy and shows the control you have over costs. The ratio used here is the operating margin and can be calculated by dividing the operating profit by sales.
Economic profitability – this evaluates profitability from an economic point of view by taking into account the assets of the business that have been used. The ratio used here is ROCE, (return on capital employed). Capital employed = fixed assets and working capital (inventory + accounts receivable – accounts payable). ROCE can be calculated by the operating profit by capital employed.
Financial profitability – this measures the amount of profit that a business can generated from its shareholders’ equity. The ratio used here is ROE (return on equity) and can be calculated by dividing net profit by shareholders’ equity.
Important things to note
Sales strategies can influence a business’ economic profitability, but it needs to optimise the use of its production capacities, current assets and/or working capital.
The financial profitability varies according to the financial structure, i.e. the mix of debt or equity of the business.
If the economic profitability of a business is higher than the average rate of business debt, its financial profitability becomes higher than its economic profitability.
In order to influence the financial profitability of a business, commercial profitability needs to increase, productivity of capital employed needs to improve and a level of optimal debt in line with market rates needs to be maintained.
Each of these ratios can be used effectively when they are compared with competing businesses and their changes are tracked over time.
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