Profit is the total amount of money a firm makes when it has subtracted all costs from its revenues. Profit = total revenue – total cost.
Profitability refers to how much profit a firm makes compared to a metric like expenses, assets, revenue or equity. It is a measure of a firm’s efficiency in translating assets and revenue into profit. Profitability can be measured with a ratio such as
- Net profit margin ratio – The percentage of profit from its revenues. This measures the amount of profit per revenue.
- Net return ratio. This is the amount of profit per asset and reflects the companies ability to generate profit for shareholders. For example, a net return ratio, could be profit/assets; profit/equity, profit on invested capital
Example of Profit vs Profitability
- For example, suppose Amazon had sales of $100bn, but a profit of only $0.5 billion. Then its profitability as a share of revenue is only 0.5%.
- A smaller retailer may have sales of $1 million, but a profit of $2 million. The smaller retailer makes considerably less profit than amazon. But, as a share of revenue, its profitability is 2%. Therefore, we can say the smaller firm has greater profitability.
Changes in profitability
Suppose Amazon increased sales from $100bn to $200bn, but profit only rose to $0.6 billion. Then we could say the profitability of Amazon is declining. – even though total profit has increased. After increasing sales to $200bn, its profit/revenue ratio is now 0.3%.
Importance of profitabilityWP Rocket
If a company has a low gross profit margin. If its ratio of profit to sales is low, then shareholders may feel the company is underperforming. They may be pressure for companies to increase prices, increase efficiency and cut costs in order to increase that profit margin. If a company consistently underperforms on profit margins, then it may be the subject to a take-over
Trade-off between profitability and total profit in the long-term
Sometimes, firms may take the business objective of maximising sales and not profitability. The argument is that if a firm makes a minimal profit, then it is able to keep prices low and maximise market share. If the firm can gain a strong market share, then this gives the potential for higher profits in the very long run. For example, for many years Amazon made hardly any profit, it’s gross profit margins were very low. But, at the time it was gaining market share and deeper market penetration. However, after several years of very low profit, it is in a position to increase both its profitability and total profit.