Profit and profitability are two terms used in accounting that have similar underlying principles. Earning a higher profit and being profitable is the main objective of companies established with a profit focus. The key difference between profit and profitability is that while profit is the net income made after covering expenses, profitability is the extent to which profit is made.
CONTENTS
1. Overview and Key Difference
2. What is Profit
3. What is Profitability
4. Side by Side Comparison – Profit vs Profitability
5. Summary
What is Profit
Profit can be simply explained as the difference between total incomes less total expenses of a business. Profit maximisation is among the top priorities of any company. Profit is categorized into various types according to the components considered to arrive at each profit amount.
E.g. gross profit, operating profit, net profit
Advantages of High-Profit Making Companies
Better Resource Utilization
The underlying idea of high profit is that the company is making wise operating, financial and investing decisions and getting the best out of its resources. The productivity of such companies is very high.
Business Expansion
Higher profits allow companies to expand into new markets and introduce new products. These type of strategies often require substantial research and development costs.
Availability of Capital
Profit is among the key components that investors are considering in evaluating investment options; thus high profits always attract them, demonstrating high investor confidence.
Borrowing Options
Companies with higher profits are generally reputed and have favourable credit ratings (estimate of ability to fulfill financial commitments). Banks and other financial institutions prefer to lend funds to such firms compared to ones with less credit worthiness.
Skilled Employee Base
Potential employees are keen to be employed in high profit making companies in order to enjoy a wider range of benefits, including significant salaries.
It is important that profit maximization is sustainable. This means that long-term viability of the business should not be compromised with the intention of making a quick profit in the short term. If the company is excessively focused on cutting costs, i.e., using low-quality materials in the production process, eliminating supervision for product defects, etc. then the short term profits may increase; however, the revenue will gradually begin to decrease since customers begin to stop purchasing company’s products.
What is Profitability
Profitability refers to the ability of a company to use its resources to generate revenues in excess of its expenses. In simple terms, this is a company’s capability of generating profits from its operations. A number of ratios are calculated using different profit figures to allow comparisons with prior periods and other similar companies and to facilitate financial decision-making. Some important ratios are,
Gross Profit Margin
This demonstrates the amount of revenue left after covering the costs of goods sold. This is a measure of how profitable and cost effective the main business activity is.
Operating Profit Margin
Operating Profit Margin measures how much revenue is left after allowing for other costs relating to the core business activity. This measures how efficiently the main business activity can be conducted.
Net Profit Margin
Measures the overall profitability and this is the final profit figure in the income statement. This takes into account all the operating and non-operating incomes and expenses.
Return on Capital Employed
ROCE is the measure that calculates how much profit the company generates with its capital employed, including both debt and equity. This ratio can be used to evaluate how efficiently the capital base is utilised.
Earnings per Share
This calculates how much profit is generated per share. This directly affects the market price of the shares. Thus, highly profitable companies have higher market prices.
Return on Equity
This assesses how much profit is generated through the funds contributed by equity shareholders. Thus, this calculates the amount of value created through equity capital.
Return on Assets
This is a measure of how profitable the company is relative to its total assets. Therefore, this provides an indication of how effectively the assets are being utilized to generate income.
Figure_1: In a large organization where there are a number of profit making divisions, their profitability can also be compared with each other
What is the difference between Profit and Profitability?
Profit vs Profitability |
|
| Profit is the net income made after covering expenses. | Profitability is the extent to which profit is made. |
| Interpretation | |
| Profit is an absolute amount. | Profitability is expressed as a percentage. |
| Comparison | |
| Profit cannot be successfully compared since it is not relative. | Profitability can be successfully compared through the use of ratios. |
Summary – Profit vs Profitability
The main difference between profit and profitability is that profit is the net income made after covering expenses whereas profitability is the extent to which profit is made. It is not sufficient to calculate the profit for the period alone since this does not allow comparisons with profits made in past years and with other similar companies. It is important to maintain an upward trend in profit where the company grows profits year on year. This amounts to increasing profitability.
Reference:
1. “What Are the Benefits of Making a Profit?” Chron.com. N.p., n.d. Web. 17 Feb. 2017.
2. “Profitability – Definition | Meaning | Example.” My Accounting Course. N.p., n.d. Web. 17 Feb. 2017.
3. Loth, Richard.”Profitability Indicator Ratios.” Investopedia. N.p., 29 May 2007. Web. 17 Feb. 2017.
Image Courtesy:
1. “Samsung Electronics Profit by segment” By Phoenix7777 – Own workData source: Earnings Release, Earnings Release Q3 2016 (CC BY-SA 4.0) via Commons Wikimedia