When running a small business, you come across a lot of jargon being tossed around. You may hear words like “profit” and “profitability” and mistake them to mean the same thing. In fact, many people who do not run a large corporation or who did not get a degree in business may use them interchangeably, thinking they are the same.
Read on to learn the difference between profit and profitability, and why it is crucial for your business.
Profit Versus Profitability: What is the Difference and Why does it Matter?
Profit is a fundamental way of looking at the earnings of a business. It is computed by taking the business’ revenues and subtracting the expenses to see how much money was gained or lost. A business may have a positive or negative profit.
For example, if a business brought in $25,000 worth of revenue and had expenses totaling $18,000, the profit would be $25,000 – $18,000, which equals $7,000.
If a business brought in $25,000 but had expenses totaling $28,000, then the profit is a negative value, meaning the business spent more than it earned. $25,000 – $28,000 = -$3,000.
Two Businesses may have the Same Profit, but Very Different Health
Profitability goes beyond finding the profit of the business to helping you figure the health of the business. Let’s take a look at two businesses that share the same profit.
Business A had revenue of $36,000 and expenses totaling $30,000. It’s profit was $6,000 ($36,000 – $30,000).
Business B had revenue of $12,000 and expenses totaling $6,000. It’s profit was $6,000 ($12,000 – $6,000).
There are a Few Ways to Determine the Profitability of Each Business
To determine the profitability of each of the above businesses, we can use the:
- profit margin ratio,
- gross margin ratio, or
- return on investment ratio
We’ll use the profit margin ratio to see how each of these businesses is doing. To calculate the profit margin ratio, use this formula: (revenue – expenses)/revenue.
Business A: ($36,000 – $30,000)/$36,000 = 0.167 or 16.67%
Business B: ($12,000 – $6,000)/$12,000 = 0.5 or 50%
A Profit Margin of 0.25, or 25%, is generally considered to be good.
Looking at the profit margins of both Business A and Business B, we can see that Business B has much better profitability and is therefore in much better shape than Business A, despite having the same profit. Business A is far below the target of 25% profit margin, while Business B is far above it.
How to Fix Low Profitability
When faced with low profitability, it is important to examine every aspect of the business’ accounts payable and accounts receivable. To increase profitability, the business will either have to find ways to cut expenses, earn more revenue, or both. For example, having employees may help a business’s profitability to a certain extent. Still, there is a tipping point where adding more employees detracts from the profitability, rather than adds to it.