Profitability of a Business: How to measure and improve profit

When it comes to remaining in business and being successful, the growth and profitability of a business are very important and necessary. A business’s profitability is its ability to earn a profit; which is the money that is left of a business’s revenue after it has paid for all expenses. Profitability in business enables a business to survive and remain attractive to investors and analysts. Hence, profitability and growth are critical to a company’s existence and long-term survival.

It is important to note that a company’s profitability is not necessarily a reflection of its cash flow. A business makes a profit when it has paid all the expenses directly related to the generation of revenue, like production costs, and other expenses related to the core business activities, and still have some money left from the revenue generated. Therefore, when assessing the profitability of a business, the accrued income and expenses are very important and should be paid attention to.

The profitability of a company can be analyzed in various ways by using any type of profitability ratio which makes use of the information on the company’s income statement. In this article, we will discuss how to increase and measure the profitability of a business, as well as the factors affecting a business’s profit.

Profitability of a business
Profitability of a business

Related: Net Income vs Net Profit Margin Differences and Similarities

Profitability of a business Explained

The profitability of a business can be defined as the business’s ability to generate profit. This is a situation whereby a business’s aggregate amount of revenue is greater than its aggregate amount of expenses for an accounting period. This is what is reported on a company’s income statement as its Net profit or Net income. Hence, a business’s net profit is the revenue left, after all the expenses related to the production, manufacture, and selling of products are deducted.

Profitability in business is important for survival because a firm can’t stay in business if it is not profitable. Investors and analysts only consider a business to be profitable when the business’s revenue is more than its expenses. Hence, the profitability of a business is the revenue from operations, less the expenses. Also, a business can achieve profit in the short term through the sale of assets that remit immediate gain on the sale. Nonetheless, this kind of profitability is not sustainable. Therefore, a company must have a business model that allows its ongoing operations to generate a profit, or be at risk of failing eventually.

Uses of profit in business

The net profit of a company goes directly to the owners of the company or shareholders or is reinvested into the company. The company’s net profit can be distributed as a dividend among the holders of common stock or can be held by the company as an addition to retained earnings. Furthermore, for any company that does not initially have investors or financing, this profit may be the company’s only capital.

Profitability is the main goal of all business ventures because, without it, the business will not survive in the long run. No business without making a profit can survive for a significant amount of time. Hence, measuring the current and past profitability of a business as well as projecting future profitability is very essential. Therefore, investors and analysts measure a business’s profitability, both current and future when evaluating a business.

Which financial report shows the profitability of a business?

The income statement is the financial report that shows the profitability of a business. Hence, the amount of profit that a business makes is reported on its income statement. The income statement is a financial report that lists all the income and expenses of a business during a period of time (usually a year). Hence, this report is traditionally used to measure the profitability of a business for the past accounting period. While a pro forma income statement is used to measure the projected profitability of a business for the upcoming accounting period. Nevertheless, a budget can be used to project profitability for a portion of a business or a particular project.

A company’s income statement shows its profitability as well as its costs and expenses during a specific period, usually over the course of a year. This is why the income statement is essential when using profitability indicators (or ratios) to assess a company. A number of different profitability ratios can be calculated using the income and expenses reported on the company’s income statement in order to analyze the company’s financial condition.

The income reported on the income statement is money generated from the activities of the business. For example, if products or services are produced and sold, the business generates income. However, money coming into the business from activities like taking loan do not create income and is not reported on the income statement but on the balance sheet as one of the company’s liabilities.

Expenses, on the other hand, are the cost of resources that are used up or consumed by the activities of the business. For instance, the cost of labor, raw materials, and consumable manufacturing supplies are expenses of a business because they are used up in the production process. Hence, the income statement is the financial report that shows the profitability of a business which is the business’s revenue from operations, less its expenses.

How to calculate profitability of a business

How to calculate the profit of a business is to subtract the company’s total expenses from its total revenue. When the expenses of a business are deducted from the revenue generated from the business activities, and a positive figure results, it is an indication that the business is profitable. Hence, the greater the figure, the more profitable the business is. However, if after deducting expenses from revenue and the result is a negative figure (loss on the income statement), it means the business is not profitable.

The profitability of a business is, therefore, the positive net difference between the business’s income and its expenses. A business measures its income for an accounting period by calculating the money the business generates through its operations and activities. While the business’s expenses are determined by calculating the number of resources (time, money, and inventory) consumed during the course of the business’s operations. Hence, this is how to calculate profitability of a business:

Net Profit (or net income) = Total Revenue – Total Expenses

OR

Net Income = Revenue − COGS − Operating Expenses − Other expenses − Interest − Taxes

Let’s look at an example of how to calculate the profit of a business:

Assuming that a business sells both tires and hubcaps and the revenue that the business generated from the sales of its tire products amounted to $1.0 million for the year while the sale of hubcaps generated $350,000 for the same period. Let’s say the business incurred fixed expenses of $400,000 and variable expenses of $250,000. In this case, here is how to calculate the profitability of the business:

Net Profit (or net income) = Total Revenue – Total Expenses

Net Profit = ($1,000,000 + $350,000) – ($400,000 + $250,000)

= $1,350,000 – $750,000

= $600,000

This means that the net profit of the business is $600,000. That is, for that year, the business makes $600,000 as profit from its operations.

See also: Net Income vs Net Revenue Differences and Similarities

How to measure profitability of a business

  1. Gross profit margin
  2. Operating profit margin
  3. Net profit margin
  4. Break-even analysis
  5. Return on capital employed (ROCE)
  6. Return on invested capital (ROIC)
  7. Return on equity (ROE)
  8. Return on assets (ROA)
Ratios that measure profitability of a business
Ratios that measure profitability of a business

Measuring the profitability of a business for the past period or projecting profitability for the coming period is the most important measure of a business’s success. A business that is highly profitable is capable of rewarding its owners with a large return on their investment whereas one that is not profitable cannot survive. Hence, investors and analysts measure the profitability of a business before making any investment decisions.

How can the profitability of a business be determined?

The profitability of a business can be determined using a variety of profitability ratios to assess the financial health of the business. These ratios are created from the income statement and can be compared with the company’s past records or the industry benchmark to determine the rate of profitability in the business. Basically, how to determine profitability of a business is to assess the two sources of profitability which are the profit margins and the rate of return (turnover). The profit margin ratios will show us the relationship between a business’s profit and sales, while the turnover ratios will show us the relationship between a business’s profits and investments.

The profit margin ratios that are used in measuring profitability of a business include gross profit margin, operating profit margin, and net profit margin. Also, the rate of return ratios such as return on assets (ROA), return on equity (ROE), return on invested capital (ROIC), and return on Capital Employed (ROCE) are used to measure the profitability of a business. Businesses can measure how profitable they are with any of these types of financial ratios. Here is how to measure profitability of a business using the following profitability ratios:

Gross profit margin

The gross profit margin is one of the ratios that are used to measure the profitability of a business. A business’s gross profit margin ratio analyzes the business’s money flow. Business owners and managers tend to keep a close eye on their gross profit margin ratio to ensure it stays stable over time. This ratio should only fluctuate when the price of goods or pricing policies changes.

Therefore, the gross profit margin is calculated by dividing a business’s gross profit by its net sales and then multiplying it by 100. The gross profit of a business is its net sales minus its cost of goods sold (COGS). Hence, this ratio is expressed as:

Gross Profit Margin = (Net Sales − COGS) / Net Sales x 100

Operating profit margin

The operating profit margin is used in measuring profitability of a business. This ratio illustrates a business’s earning potential from its current operations. A healthy operating profit margin would definitely increase from one accounting period to the next. Hence, this ratio is used by businesses to calculate their competitive position within an industry. The operating profit margin is calculated by dividing the business’s operating income by its net sales and then multiplying it by 100.

Hence, this ratio is expressed as:

Operating Margin = Operating Income / Revenue x 100

Net profit margin ratio

The net profit margin is one of the common ratios that are used to measure the profitability of a business. Each industry has a different average net profit margin ratio, thus, business owners compare their business’s net profit margin to the industry average in order to assess yearly performance. This ratio is different from an operating profit margin ratio because it accounts for income after taxes. Hence, the net profit margin of a business calculates the amount of profit the business can extract from its total revenue stream.

The net profit margin is calculated by dividing net income by net sales and then multiplying the number by 100. Hence, this ratio is expressed as:

Net profit margin = (Net income / Revenue) x 100

Break-even analysis

A break-even analysis is also important when measuring a business’s profitability. This analysis involves determining the point at which a business’s revenues equal expenses. In order to calculate this, a business will determine its fixed expenses, variable expenses, and sales. The business’s break-even point is when sales equal fixed expenses plus variable expenses.

This break-even point can be expressed in either unit sold or dollar amounts and is useful in determining how a business will react when sales slump. Hence, this analysis is incredibly valuable when planning for a business’s future.

Return on capital employed (ROCE)

One of the ratios that measure profitability of a business is the Return on capital employed (ROCE). This ratio is used to measure the profitability of a business and its capital efficiency. Hence, it can help determine how well a business is generating profits from its capital as it is put to use. Financial managers, stakeholders, and potential investors make use of this ratio when analyzing a company for investment.

ROCE is expressed as:

ROCE = EBIT / Capital Employed

Where:

  • EBIT=Earnings before interest and tax
  • Capital Employed= Total assets – Current liabilities

Return on invested capital (ROIC)

Return on invested capital (ROIC) is a profitability ratio that evaluates a business’s efficiency in allocating capital to profitable investments. This ratio gives us a view of how well a business is using its capital to generate profits. Hence, the ROIC is calculated by dividing the net operating profit after tax (NOPAT) by the invested capital. ROIC is therefore expressed as:

ROIC = Net operating profit after tax (NOPAT) / Invested Capital

Or, ROIC = (Net income – Dividends) / (Debt + Equity)

Return on equity (ROE)

Return on equity (ROE) is also one of the profitability ratios that measure a company’s financial performance. It is calculated by dividing a business’s net profit (or net income) by its shareholders’ equity. This ratio measures the profitability of a business. Hence, it is expressed as:

ROE = Net Income / Average Shareholders’ Equity

Return on assets (ROA)

A return on assets ratio measures the profitability of a business by comparing the business’s assets and revenue. The higher the ratio, the more efficient the business. Hence, to calculate a business’s return on assets, divide its net income before taxes by its total assets, and then multiply it by 100.

Hence, the ratio is expressed as:

ROA = Net Income / Total Assets x 100

Related: Is Net Income on Balance Sheet or Income Statement?

Factors that affect profitability of a business

  1. Price
  2. Variable and fixed costs
  3. Degree of competition
  4. Strength of demand
  5. Relative costs
  6. Exchange rate
  7. State of the economy
  8. Economies of scale
  9. Management
  10. Objectives of the business
  11. Advertising and marketing strategies
Factors that affect profitability of a business
Factors that affect the profitability of a business

Generally, there are factors that affect a business’s profitability such as demand for the business’s products, the cost of making these products, the general economy, and the competition that the business faces. These factors play a major role in how well a business makes profits. Some of these profitability factors can be controlled while some can’t. Therefore, in business, understanding and working on the factors affecting profitability of a business is essential for a successful business.

Price

Price is one of the factors affecting profitability of a business because it is what the business charges for the products or services that it delivers to customers. It happens to be one of the most important factors that determine profit. When a business is developing its price point, the goal is to charge as much as it can for what it is producing, as long as the price is still competitive. This is important because the price of a product or service definitely plays a role in a business’s profitability.

Therefore, a business’s pricing strategy is an essential tool when it comes to the business’s profitability. Hence, a business has to differentiate itself, either by establishing itself as a low-price leader or choosing to charge a premium for its goods or services.

Variable and fixed costs

Variable and fixed costs are one of the profitability factors in business. These costs affect the profitability of a business. The variable costs are costs such as the cost of labor, utilities, commission, distribution, and raw materials that change with revenue. These costs will increase as revenue increases and are a central part of determining a product’s contribution margin which is the measure used to determine a company’s target profit or break-even level.

Fixed costs, on the other hand, stay pretty stable regardless of the business’s revenue. They include the cost of business expenses such as overhead items, rent, interest payments, and insurance that don’t change even when there’s an increase or decrease in the number of goods or services sold or produced. These costs are one of the factors that play a role in price points which is an important factor for profit.

Therefore, fully understanding the business’s variable and fixed costs, would enable you to consider other ways to increase your profit. Variable and fixed costs as a profitability factor would play an important role in having the impact you want on your profit levels. This is why profitability calculations such as gross margin, profit margin, and net income are usually calculated with a combination of variable and fixed costs. Therefore, by performing variable and fixed cost analysis, a business can easily identify how scaling or decreasing output can impact profit calculations.

Degree of competition

One of the factors that affect business profit is the degree of competition. Competition is one of the important factors in a business’s profitability in the sense that if a business has monopoly power, it will have little competition. This means that demand will be more inelastic for the business which will enable it to increase profits by increasing its price. Profitable companies, such as Microsoft and Google are examples of companies that have developed a degree of monopoly power, with limited competition.

On the other hand, if the market is very competitive, then the profitability of a business will be lower because most consumers would prefer to buy from the cheapest firms. Also, market contestability (how easy it is for new businesses to enter the market) is another important factor in competition. If entry is easy for new businesses, then the already existing businesses will always face the threat of competition (even if it is just a hit-and-run competition) which will reduce their profit levels.

Strength of demand

The strength of demand is also one of the factors affecting a business’s profit. According to the law of supply and demand, when supply exceeds demand for a good or service, prices will fall and when demand exceeds supply, prices will rise. Therefore, in line with this fundamental economic principle, if a business’s strength of demand is weak, its prices will fall which would lead to less profitability for the business and if the business’s strength of demand is strong, its prices will rise which would result in more profitability in business.

Relative costs

One of the major factors affecting profitability of a business is its relative costs. This factor plays a role in the profitability of a business because, an increase in relative costs such as labor costs, raw material costs, and the cost of rent will decrease profits. That is if the production costs of a business such as rent, raw material, and labor increases, the business’s profitability will inevitably be lowered.

For example, a devaluation of an exchange rate could increase the cost of imports, which will cause businesses that import raw materials to face an increase in costs. This is because if the exchange rate faces devaluation, the cost of imports will increase which in turn will cause businesses using imported raw materials to bear higher production expenses.

Exchange rate

The exchange rate can also affect the profitability of a business if the business relies on exports. A depreciation in the exchange rate will increase the profitability of a business. That is, a fall in the exchange rate will make exports cheaper to foreign buyers. Hence, the business can sell more or choose to have a bigger profit margin. On the flip side, if a business imports raw materials, depreciation will increase the costs of production which will decrease the profitability of the business.

State of the economy

The state of an economy is also one of the major factors affecting a business’s profit. The state of the economy in which a business operates has a role to play in its profitability. This is because, during seasons of economic growth, consumer confidence tends to be high, unemployment rates are low and people tend to have greater disposable income. This leads to more people patronizing businesses which increases the profitability of a business. That is, during seasons of economic growth, there will be increased demand for most products and some great opportunities for businesses.

On the flip side, during an economic downturn, people tend to save as more jobs are cut. Therefore, most businesses suffer less patronage. For example, in times of recession, manufacturers of luxury sports cars tend to suffer but when there is economic growth, they benefit. Therefore, the state of the economy is a profitability factor as economic growth leads to increased revenue and profitability in a business.

Economies of scale

Economies of scale affect the profitability of a business. They are cost advantages reaped by businesses when production becomes efficient. Generally, when it comes to economies of scale, the size of the business matters; the larger the business, the more cost savings. They are important because they can help provide businesses with a competitive advantage in their industry which will increase their profitability.

Hence, businesses can achieve economies of scale by increasing production and lowering costs, because the costs of production are spread over a larger number of goods. That is, a business with high fixed costs will need to produce a lot to benefit from economies of scale and produce on the minimum efficient scale, otherwise, the average costs will be too high.

Management

The management of a business is one of the profitability factors. It plays an important role in the profitability of a business and therefore affects a business’s profit level. Successful and effective management of a business is very crucial for long-term growth and profitability in business. A business that doesn’t have a strong team of managers striving hard to push it forward will not grow.

When a business has proficient managers, it grows, because these managers incorporate their leadership skills to ensure the timely completion of projects, and also motivate their team toward achieving the business’s targets. Inefficient and careless management (such as poor decision-making), on the other hand, will cause a decline in workers’ morale and indirectly contribute to lower productivity and decreased profitability.

Objectives of the business

The objectives of a business are also vital for profitability. Some businesses are profit-maximizing while some are not. Some businesses may only seek to increase market share and in such cases, sacrifice profitability to gain market share. Whereas, for some, their core objective is to make profits. Hence, a business’s objective is one of the factors that affect its profitability.

Advertising and marketing strategies

The advertising and marketing strategies that a business uses are one of the factors that affect a business’s profit. This is because a powerful and successful advertising campaign can increase demand and give a product more inelastic demand. However, the increased revenue will need to cover the costs of the advertising and market strategies implemented. Therefore, one must ensure that the increased revenue is able to compensate for the expenses used for marketing. That is why word of mouth remains one of the cheapest and best product marketing strategies.

A business’s marketing strategy and its ability to strike a chord with its potential customers play an important role in determining the profitability of a business. An appealing and compelling advertising campaign will always spread the word about a business’s product and attract potential buyers to the brand which increases the profitability of a business. There are a lot of marketing strategies that businesses can use to increase their profitability such as digital and physical marketing strategy, content marketing strategy, inbound email marketing, societal marketing, etc.

See also: What is the Sociological Model? Definition and Types

How to improve the profitability of a business

  1. Make effective and productive changes to the business’s operating procedures
  2. Stay visible and connected
  3. Maximize the business’s cash flow
  4. Reduce costs when possible
  5. Raise the marketing bar

The profitability of a business is one of the metrics that can be used to evaluate it. Therefore, increasing a business’s profitability is a long-range goal of a majority of business owners and entrepreneurs. This is because a greater profit level indicates more money for the business and investors. Also, as a business owner, increasing profitability in business enables you to build up a cushion against economic downturns, or competitors undercutting you.

Every business has the ability to improve its profitability. Sometimes, a single factor can significantly increase the profitability of a business, but for most businesses, increasing its profitability means gradually implementing a number of small improvements. Here are how to increase profitability in business:

Make effective and productive changes to the business’s operating procedures

Generating more sales while reducing expenses is one of the ways to improve the profitability of a business. In order to increase sales, a business can try cross-selling; that is, offering new services or goods that complement its current offerings. This would be an effective and productive change to the business’s operating procedures. For instance, a poultry farm business can also sell poultry feeds.

Also, another operational change that can improve the profitability of a business is incentivizing new customers with special deals, discounts, or short-term giveaways to try the business’s product or services. In an attempt to make an operational change, a business can try switching to a relationship-based sales model that gets customers coming back by offering monthly or yearly service plans, or a bundle of visits at a discounted price.

Stay visible and connected

Staying visible and connected is one of the major ways to improve the profitability of a business. Visibility via accreditations, licenses, and certifications for your business or individual employees is one way to set your business apart from its competition.

In this time and age, a business can stay connected and visible by taking its reputation online, using social media, a website, and a blog to connect with clients and make strategic alliances. Also, a business can stay visible by using advertisement sharing with complementary businesses, taking advantage of affiliate marketing tools, and finding ways to leverage referral selling in order to drive new customers to the business’s site.

Maximize the business’s cash flow

Maximizing your business’s cash flow is one sure way to increase profitability in business. A business’s cash flow is the net amount of cash that is going in and out of the business. A business’s success is determined by its ability to create positive cash flows through the normal course of its business operations.

Therefore, in order to gain control of your business’s cash flow, consider implementing new policies such as offering sales discounts to customers who pay early, using electronic payments for bill paying, and forming a buying cooperative with other businesses.

Also, one of the ideal ways to achieve a stable cash flow is to offer ongoing payment plans or pre-paid retainers for your clients. Other ways to maximize your cash flow are to lease and not buy, improve inventory, conduct consumer credit checks, and use high-interest savings accounts.

Reduce costs when possible

Cutting down on expenses when necessary is one of the ways to improve the profitability of a business. There are several ways you can reduce costs and increase the profitability of your business. When making the purchase of raw materials, always specify supplies of the right quality in order to minimize wastage. Also, negotiate good prices and periodically compare suppliers. Always try to eliminate unnecessary costs in order to cut overheads and keep all costs under constant review.

Furthermore, when it comes to utilities, ensure that you are on the best tariff. For your bank charges, negotiate lower bank charges and ask a different broker to conduct a review of your insurance. Always maximize the cost-effectiveness of your assets and base your asset purchase decisions on lifetime costs. Also, your human assets are crucial, so ensure you are using your employees effectively. Check to confirm if it will be more cost-effective to hire part-time help instead of a full-time employee to do some of the company’s tasks. In addition, if there is surplus space on your premises, you can consider sub-letting it.

Raise the marketing bar

Marketing is very essential when it comes to improving the profitability of a business. If people don’t know about your product or service, how will they patronize you? Marketing creates awareness and has the power to convert potential customers to return customers. Hence, raising the marketing bar for your business will improve your sales and profitability.

It is important that you give your business an instant presence through online networks such as Facebook, Twitter, YouTube, Instagram, and LinkedIn. You can set up group meetings, sales presentations, and special promotions using webinars. Also, offering tutorials, demos, or new certification sessions are a good way to connect with your target audience.

Marketing can be digital, physical, or both. Just measure all your marketing strategies to see which ones are cost-effective to utilize. Also, you can make every one of your employees a salesperson. Every company’s employee has the opportunity to spread the company’s message and engage in potential sales-generating behavior. They can pitch in to help by cutting costs, selling, networking on the web, and marketing. An effective marketing campaign is definitely one of the best ways to increase profitability in business.

See also: How to improve ROI in digital marketing

Importance of profitability in business

  1. Gives room for expansion in business operations
  2. Ability to take up loans
  3. Attracts financing from investors
  4. Ability to hire more employees

The success of every business depends on its ability to continually make profits. Making a profit is important to every business because profitability in business impacts whether a business can attract investors to fund its operations, secure financing from a bank, or grow its business. Businesses can’t remain in business without making a profit. Hence, business owners must understand the importance of profitability in business and develop strategies that will give their business the best chance of remaining profitable. Here are some reasons why profitability in business is important:

Gives room for expansion in business operations

One of the major importance of profit in a business is that it gives room for expansion. Any business that desires to expand its operation needs to make profits. Earning a profit allows a company to open other business locations, target other markets, acquire another business, and expand its operations into foreign territories. The essence of business expansion is to further increase profits.

However, making a profit is not the only factor that influences the decision of whether to expand a business. If there is a desire to grow a business, the management and back office team should be able to take on additional responsibility. They can create a business plan for expansion and analyze trends and economic factors that affect the business.

Ability to take up loans

Many businesses depend on debt financing for their operations. Debt financing usually requires a business to repay the money borrowed to the creditor with interest which usually includes borrowing money from a bank. A business’s profitability plays an important role in whether a bank would lend the business money or not. This is because a business that cannot turn a profit is usually seen as a risk for default by a lender. Also, apart from profitability, a business owner’s credit score and collateral are determining factors in lending decisions.

Attracts financing from investors

Another importance of profitability in business is that it attracts financing from investors. Some businesses prefer to bring in private investors to secure funding for their operations. A business that earns continual profits is usually seen as a potentially good investment option because investors believe that there is a good chance to earn an attractive return on their investment. Therefore, attracting investors depends on a company’s ability to show the monetary benefits of investing in its business. This is why business owners prepare to show potential investors their ability to generate profits in previous years and their plans to continue to earn profits in the future.

Ability to hire more employees

Being able to hire more employees is another importance of profitability in business. A part of a growing business includes hiring additional employees who can handle the growing responsibilities within the company. Hence, a profitable business has a better chance of affording to pay new employees’ salaries compared to a company that is struggling financially. Hiring new employees is an important element of running a growing business. Therefore, the importance of profit in a business is that it can give the business the ability to hire more employees.

Related: Why digital marketing is important for small business

Cash Flow vs Profitability in business

The revenue from a business’s sale of products or services is a primary factor for the profitability of a business. However, in as much as making money on sales, generates income, it doesn’t necessarily make a business profitable. That is, the profitability of a business relates to the business’s after-expenses income, and not necessarily its cash flows. Therefore, if a business is recording its transactions under the accrual basis of accounting, it is quite possible that the profitability of the business will not be matched by the cash flows generated by the business. This is because some accrual-basis transactions (like depreciation) do not involve cash flows.

The US Generally Accepted Accounting Matching Principle (US GAAP), requires that when a business adopts accrual-based accounting, its revenue and expenses should both be recorded in the period that they are incurred. On the other hand, it is different for cash accounting, the US GAAP requires that revenue and expenses should be recorded at the time that cash is received or distributed. Nevertheless, in most cases, a business operates under an accrual-based accounting policy. Hence, in as much as both accounting methods give us the same result, in the end, accrual-based accounting is considered to be a more inclusive and transparent method of record-keeping.

This means that profitability is not cash flow. People usually mistakenly believe that a profitable business will not encounter cash flow problems. Even though profitability and cash flow are closely related, they are different. An income statement lists the income and expenses of a business which shows the profitability of a business while a cash flow statement lists the cash inflows and cash outflows of a business showing the liquidity of the business.

Nevertheless, many income items are also cash inflows. For instance, the sale of products and services is usually both income and cash inflows. The timing is also usually the same (cash method of accounting) as long as cash is received and deposited in the business’s account at the time of the sale. Also, many expense items are cash outflow items. For instance, the purchase of raw materials is both an expense and a cash outflow item. The timing is also the same (cash method of accounting) if cash is paid at the time of purchase.

Conversely, there are many cash items that are not income and expense items, and vice versa. For instance, the purchase of machinery is a cash outflow if you pay cash at the time of purchase. If you borrowed money for the purchase using a term loan, the down payment is a cash outflow at the time of purchase and the annual principal and interest payments are cash outflows each year.

Related: Why email marketing is important for small business

Conclusion

In conclusion, a business’s main objective is to make money. The amount of money made after considering every avenue of expenses and earnings is the profitability of the business. Hence, if a business is not profitable, it will not last. More so, even businesses that are extremely profitable and have bright futures are subject to failure if they cannot maintain profitable operations.

The success of every business depends on its ability to continually make profits. Hence, the profitability of a business is used when analyzing whether or not a business is a going concern and can continue to operate in its current capacity. Making a profit is definitely important to every business because profitability in business impacts whether a business can attract investors to fund its operations, secure financing from a bank, or grow its business.

Video: Measuring Profitability and Growth: 4 ways to measure the profitability of a company and grow your business

A video explaining the profitability of a business, how to measure and increase it
Obotu Agape Oguche