Most businesses today focus on covering their expenses to reach their financial goals. However, to achieve future profitability, business owners must first understand the differences between two metrics that affect the business performance and financial statements of any organization: profitability and profit.
While both terms are closely connected and are often used interchangeably, they are not the same.
Definition of profit
Profit is an absolute number that comes directly out of revenue. It is the amount of cash a company earns after paying its expenses and taxes.
Profit is calculated by taking total revenues (income from sales) minus total expenses (costs incurred for goods sold).
This metric appears on an organization’s income statement and allows executive teams to decide whether their business model allows them to generate enough cash or not, based on their cash inflow and cash outflow.
Regardless of a company’s size, scope, or industry, all businesses’ primary objective is to generate profits. However, accounting profits don’t always mean that a business is performing well, as this will also depend on the money an organization is losing.
Definition of profitability
Profitability is the metric that calculates how efficient a company is, and ultimately its success or failure.
The key difference between profit and profitability is that profit is an absolute number, while profitability is a relative one.
Profitability ratios provide business owners with a deeper understanding of how efficiently their company is turning money into revenue during a certain period of time. It measures the ability of an organization to generate returns on investments (ROI) based on its resources and company size compared to other investments.
A clear picture of profitability helps corporate leadership evaluate their company’s financial health, asses whether they are performing well enough to be among the top-quartile companies, and decide whether or not they should invest in a particular product or company growth opportunities.
Profitability index application
Investors usually don’t simply calculate the profit ratio, they look at whether the business’ finances are sound and measure their profitability ratios to see how effectively resources and capital are being utilized.
Business owners who want to know whether they should pursue a particular project can explore a Profitability Index. This metric evaluates if a project is worthwhile or not, as it provides insight into its benefits and operating costs.
The Profitability Index (PI), also referred to as Value Investment Ratio (VIR), measures the relationship between the benefits of a project and its cost drivers. It is calculated by dividing the present value of future cash flow by the initial amount invested in a project. Higher PIs mean greater project attractiveness.
However, one thing to keep in mind is that the Profitability Index doesn’t consider a project size. Given that, when comparing the desirability of several projects, it is important to remember that projects with larger cash inflows might not produce the highest profit margins.
