Eric

· 05 Nov 2021

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Profitability of business

    The ultimate goal of any business is to make as much profit as possible.  The ability to

generate more income compared to the incurred expenses. Profitability involves the

capability of a company or business to make a profit.  Different mechanisms are used to

determine when a business is making a profit.


How do you measure profitability in a business?.

There are different ways to measure profitability.

i.     Profitability Ratios

       A profitability ratio entails the assessment of a business capability to generate earnings

as compared to its revenue and operating costs.  It is an indicator of how effectively the

business uses its resources to earn more profits and enhance value.  Further, margin ratios

and gross margin ratios are used to calculate sales income and gross profit, respectively.

Formula to calculate Gross profit margin:

Gross Profit Margin=Net sales- Cost of Goods Sold

ii.    Break-Even Analysis

       The break-Even analysis involves a point in a business’s financial life where expenses

equal revenues. It is conducted into two stages.  Before reaching the break-even point, one

is a point where the labour and other expenses cost exceeds the gross income.  Secondly is

the breaking-even point where the gross revenue exceeds the cost of expenses. Break-even

analysis helps in establishing the relationship between the business revenue, product cost

and sales volume.

iii.    Return on Assets and Return on Investment

      Return ratios outline a company’s capability to give returns on any invested capital.

Commonly adopted return ratios include:

•    Return on Assets

       Return on Assets ratio entails a profitability ratio that shows the profitability of a

business compared to its assets. In effect, it shows the efficiency with which the firm uses

its assets.

      The higher the return, the more the efficiency and production rate in utilizing a

business's resources.

The formula for Return on Assets = Net income After Tax/Total Assets.

•    Return on Equity

        Return on Equity indicates the financial performance of a business.  Also, it shows the

total return on the equity capital of the company. In effect, it outlines a business's ability to

turn equity investments into profit.

The formula for Return on Equity = Net Annual Income /Shareholder's Equity.

Why analyze profitability in business?

Profitability in business a have several benefits.

i.    Ability to secure financial support from banking institutions.

     Financial institutions will need only lender their loans and grants to companies and

business that demonstrates the ability to make a profit.  Nonprofit making businesses

possess a risk of defaulting on loans.

ii.    The attraction of investors.

       How much profit return will I earn from such investment?  Is one crucial question that

investors analyze when they seek to engage in any investment business.  Demonstrated

continual profit margin attracts investors to a company.

iii.    Growth of a business

     Profit margin is one of the tools for the growth of a company or business. Much profit lays

the foundation for the ability of the business to expand its services to different regions. For

example, banking institutions can establish new satellite branches in the other areas.

iv.    Ability to respond to the dynamic business environment.

      What was selling today may not be selling tomorrow. Such dynamics are ever-present in

a business environment. In effect, the ability of a business to be responsive to such changes

is attached to its profitability.

  In conclusion, understanding of profitability mechanism in a business is of the essence. The

more generation of profit, the higher the growth and continuity of business.

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