What it means
At its simplest, profitability asks whether the money coming in is greater than the money going out. If revenue is $100 and costs are $90, the business made a profit of $10, but profitability asks how good that $10 is in relation to the effort and capital required to earn it.
That is why profitability is expressed as ratios rather than as a single profit figure. Common measures include gross margin (profit after direct costs), operating margin (profit after running costs) and net margin (profit after everything, including interest and tax).
Return on assets and return on equity measure how well the business turns its resources and shareholders' money into profit. Profitability matters to every part of an organisation.
Owners use it to judge whether the business is worth running, lenders use it to decide whether interest can be paid, and managers use it to decide which products, customers and locations deserve more investment. It is important to separate profit from cash.
A company can show strong accounting profit while running short of cash because customers pay slowly, and it can generate cash in a loss-making year by selling assets or borrowing. Profitability is a measure of earning power, not of how much cash is in the bank today.
Trends often tell you more than a single year's figure. A margin that is slowly shrinking can signal rising costs or pricing pressure long before the profit itself falls, and a margin that is climbing may show that the business is gaining scale or pricing power.
Context also changes what counts as good. A supermarket can be healthy with a net margin of a few per cent, while a software firm might expect a much higher figure, so comparisons should be made against similar businesses and against the firm's own history.
In practice
Real-world examples.
Example
A coffee chain compares its three shops. Each sells about $800,000 a year, but the shop in the business district earns a 15% net margin while the one in the suburbs earns 4%, which leads the owner to renegotiate the suburban rent.
Example
A software company sees revenue rise from $5,000,000 to $7,000,000, a 40% increase, but net profit falls from $600,000 to $350,000. The finance team investigates and finds that discounts and extra support staff have eaten the extra revenue.
Example
A farmer compares two crops. Wheat earns $90,000 of profit on $400,000 of invested costs, while sunflowers earn $60,000 on $200,000, so sunflowers return 30% on the money tied up against 22.5% for wheat.
Formula
Calculation
The net profit margin shows how much of each dollar of sales ends up as profit:
Net profit margin = Net profit / Revenue x 100
Return on assets = Net profit / Total assets x 100
Suppose a design agency has revenue of $2,500,000, net profit of $250,000 and total assets of $2,000,000.
Net profit margin = $250,000 / $2,500,000 x 100 = 10%.
Return on assets = $250,000 / $2,000,000 x 100 = 12.5%.
This means the agency keeps 10 cents of profit from every dollar of sales and earns 12.5 cents of profit for every dollar of assets it uses.Case study
Seen in the real world.
Oakhaven Print is an illustrative, fictional commercial printer that celebrated when its sales grew by 30% in a single year. The owner was puzzled when the bank balance did not look any healthier.
His accountant produced a profitability report by customer. The largest new customer accounted for $600,000 of revenue but was priced so tightly that it produced a net margin of just 1%, while smaller regular clients delivered margins of around 12%.
The company stopped chasing low-margin volume, raised prices on the big account and put more effort into the smaller clients. Revenue grew more slowly the next year, but net profit nearly doubled. The illustrative lesson is that growth and profitability are different things, and only the second pays the bills.
Watch out
Common mistakes.
- Equating high revenue with high profitability, when a business can sell a great deal and still earn very little after costs.
- Using profit and cash flow as if they were the same, even though profit includes non-cash items and timing differences.
- Comparing margins across industries without allowing for differences in business model, capital needs and typical pricing.
Questions
People also ask.
Which profitability ratio should I use?
It depends on the question, since margins show how well sales convert to profit while return ratios show how well the assets or invested money are used.
Can a business be profitable and still fail?
Yes, if it runs out of cash before the profit is collected, which is a common problem for fast-growing firms with long payment terms.
How can profitability be improved?
The main routes are raising prices, cutting costs, selling a better mix of products and using assets more efficiently, and the right choice depends on where the biggest gap is.
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