Profitability vs. Profit: The Difference and How to Measure Ratios

What is profitability?

Profitability measures a company's capacity to make money relative to its expenses or investments. A company is profitable when its revenue growth surpasses its spending and operating costs.

In contrast, a company is unprofitable when its expenses exceed its revenue, resulting in a net loss or negative profit.

Profitability is a critical financial indicator that shows how effectively a company manages its resources to generate income. It is essential to the long-term viability of a business and its products and services.

5 factors that affect business profitability

Several key factors can impact a company's profitability. Understanding these factors and how they relate to the organization’s financial health is crucial for business owners and managers seeking to maximize profitability.

1. Cost of goods sold

The cost of goods sold (COGS) refers to the expenses a company incurs to produce its products or services. And it's one of many accounting basics every retailer should know. It includes the cost of raw materials, labor, and other production-related expenses. The lower the cost of goods sold, the higher the gross profit margin, contributing to higher profitability.

2. Operating expenses

Rent, salaries, and utilities can significantly impact a company's profitability. High operating expenses can reduce profit margins, while effective cost management can increase profitability.

3. Productivity

A company’s level of productivity affects its profitability as it impacts the efficiency of the production process. The more efficient a business is in producing goods or services, the lower its production costs and the higher its profit margins.

4. Demand

Demand refers to the number of products or services consumers are willing to purchase. A high demand for a product or service can lead to increased sales and higher profits, while a low demand can lead to reduced sales and profits.

5. Competition

A highly competitive industry may lead to lower profit margins. It can impact a company's profitability by forcing it to lower prices, increase marketing spending, improve product quality, or innovate to retain or gain market share.

The difference between profit and profitability

Profit and profitability are related business concepts, but they are not synonymous. Profit is how much money a company has left after deducting all expenses.

Profitability is a measurement of the company’s efficiency in generating profit relative to its expenses. Profit is a key indicator of financial success, while profitability is a more comprehensive measure of financial health. 

What is an example of profitability?

Here's a basic example of profitability. Let's say you sell custom hoodies for dogs on a marketplace like Etsy. You sell each sweater for $23, and last month, you sold 10 for a total revenue of $230.

That month, you bought 200 hoodies wholesale for $100 and spent another $50 on the heat-transfer vinyl you use to customize each order. Using our profitability or gross profit margin equation, we find our profitability was around 35%.

That's just a basic example. In reality, your costs to make or sell a product may be much higher and include things like shipping and marketing costs, marketplace fees, price changes, and other factors. That's why determining costs is one of the many challenges in reporting profitability.

Not only can you determine profitability for a single product, like the example above, but you can also do it for an entire catalog. If you sell items through other channels, like local fairs or a custom webstore, each can have its own profitability.

Some sources suggest the ideal profit margin is between 5% and 20%, with 5% being low, 10% being healthy, and 20% being high. 

Why profitability matters and companies should focus on profitability and profit

While profit is critical for businesses, focusing on it alone can be misleading and unsustainable in the long run. A company with high profits but has low profitability may be spending too much on expenses.

In contrast, a company with low profits but high profitability may be effectively managing its resources. Therefore, companies should focus on improving profit and profitability to maximize financial success.

There are several benefits of assessing profitability vs. profit:

1. It helps with planning and sustainability

By focusing on profitability, businesses can make better decisions about long-term planning, such as investing in new products or expanding into new markets. Profitability measures help business owners evaluate the potential return on investment and make informed decisions.

2. It protects against unexpected expenses

By maintaining profitability, businesses are better equipped to handle unexpected expenses, such as market downturns, regulatory changes, or natural disasters. This course of action provides a cushion for businesses and helps them to remain financially stable in the face of uncertainty.

3. It increases investor confidence

A business with a strong profitability track record is more likely to attract investors, as it indicates a high potential for future growth and sustainability. Investors can provide the required capital to fuel business expansion and achieve long-term success.

4. It provides a more accurate measure of financial health

Profitability measures revenue and expenses, giving a more complete picture of the company's financial health. This picture helps to identify areas where the company can improve efficiency and reduce costs to increase profitability.

Note that profitability isn’t merely a KPI. It’s a fundamental component that drives every business decision you make. Leverage tools like Webgility’s business analytics solution to gain actionable insights into profitability and all the analytics you need to make data-informed decisions.

Ways to measure profitability using profitability ratios

Profitability ratios are financial metrics used to evaluate a company’s financial health, performance, and ability to generate profits. These ratios can help analysts, investors, and business owners assess the company's profitability, efficiency, and overall financial strength.

To measure your company’s profitability using these ratios, calculate each ratio and compare it to industry benchmarks or your historical performance. A higher ratio indicates better profitability, while a lower ratio may suggest potential issues in the company's financial performance.

There are six common profitability ratios.

1. Gross profit margin

This profitability ratio measures the percentage of revenue that exceeds the cost of goods sold. It provides insight into a company's ability to cover its operating expenses and generate profits from its sales.

A higher gross profit margin indicates better efficiency and profitability, while a lower margin suggests potential financial issues.

To calculate your gross margin, subtract your revenue from your COGS, divide by total revenue, and multiply by 100.

Gross profit margin = ((revenue – COGS) / revenue) x 100

For example, if a company generates $1,000,000 in revenue and its COGS is $600,000, the gross profit margin would be calculated as follows:

Gross profit margin = (($1,000,000 - $600,000) / $1,000,000) x 100 = 40%

2. Operating profit margin

This profitability ratio represents the profit a company generates from its core operations before paying interest and taxes. It provides insight into a company's ability to control costs and generate profits from its core business activities.

A higher operating profit margin indicates better efficiency, while a lower margin suggests a need to take corrective measures to improve financial performance.

To calculate your operating margin, subtract your revenue from your COGS and operating expenses. Then divide by revenue and multiply by 100.

Operating profit margin = ((revenue – COGS – operating expenses) / revenue) x 100

For example, if a company generates $1,000,000 in revenue, its COGS is $600,000, and its operating expenses are $200,000, the operating profit margin would be as follows:

Operating profit margin = (($1,000,000 – $600,000 – $200,000) / $1,000,000) x 100 = 20%

3. Net profit margin

This profitability ratio represents the profit a company generates after deducting all expenses, including interest and taxes. It provides insight into a company's overall profitability and ability to generate profits for its shareholders.

A higher net profit margin indicates better efficiency and profitability, while a lower margin suggests potential financial issues.

Your net profit margin is calculated by dividing net income and revenue and multiplying by 100.

Net profit margin = (net income / revenue) x 100

Where net income = revenue – COGS – operating expenses – interest – taxes

For example, if a company generates $1,000,000 in revenue and has a net income of $100,000, the net profit margin would be calculated as follows:

Net profit margin = ($100,000 / $1,000,000) x 100 = 10%

4. Return on assets (ROA)

This profitability ratio indicates the profit a company generates for each dollar of assets it holds. It provides insight into a company's efficiency in using its assets to generate profits.

A higher ROA indicates better efficiency and profitability, while a lower ROA suggests the company may need to improve its asset management or profitability strategies.

To calculate your ROA, divide your net income and average total assets and multiply by 100.

ROA = (net income / average total assets) x 100

For example, if a company generates $100,000 in net income and has average total assets of $1,000,000, the ROA would be calculated as follows:

ROA = ($100,000 / $1,000,000) x 100 = 10%

5. Return on equity (ROE)

This profitability ratio indicates the profit a company generates for each dollar of shareholders' equity. It provides insight into a company's ability to generate profits for its shareholders.

A higher ROE indicates better efficiency and profitability, while a lower ROE suggests that the company may need to increase shareholder equity to boost returns.

To calculate your ROI, subtract your investment's current value from the investment's cost. Then divide that value by the investment cost and multiply by 100.

ROE = (net income / shareholder’s equity) x 100

For example, if a company generates $100,000 in net income and has shareholder’s equity of $500,000, the ROE would be calculated as follows:

ROE = ($100,000 / $500,000) x 100 = 20%

6. Return on investment (ROI)

This profitability ratio measures the return or profit generated on an investment relative to the cost of that investment. It provides insight into the efficiency of an investment and helps investors make informed decisions.

A higher ROI indicates a better return on investment, while a negative ROI suggests that the investment has lost money.

To calculate your ROI, subtract the current value of your investment from the cost of the investment. Then divide that value by the cost of the investment and multiply by 100.

ROI = ((current value of investment – cost of investment) / cost of investment) x 100

For example, if an investor purchases a stock for $10 and sells it for $12, the ROI would be calculated as follows:

ROI = (($12 - $10) / $10) x 100 = 20%

What is the profitability index?

The profitability index (PI) — also called the profit investment ratio (PIR), cost-benefit ratio, or value investment ratio (VIR) — is a financial metric used to assess the potential profitability of an investment.

It’s useful for comparing investment opportunities with different initial costs and cash flow patterns as it accounts for the time value of money. It is frequently used in capital budgeting to decide whether or not a project is worth pursuing.

PI = present value of future cash flows / initial investment

For example, an investor gives an initial investment of $100,000 for a project and expects to receive future cash flows of $150,000 over the life of the project. The present value of these future cash flows is estimated to be $130,000.

You can calculate the profitability index using the formula: 

PI = $130,000 / $100,000 = 1.3

So for every dollar invested in the project, the investor expects to receive $1.30 in the present value of future cash flows. A profitability index greater than one indicates that the investment is expected to generate positive returns. But a profitability index less than one suggests that the investment may not be profitable.

Strategies to help your business increase profitability

Businesses must constantly focus on increasing profitability to stand out, sustain growth, and ensure financial stability. The following strategies can help you improve profitability, boost profits, and achieve your business goals.

1. Streamline and automate processes where possible

Identify operational inefficiencies and streamline processes to reduce waste and increase productivity. Ecommerce automation software, for example, can reduce repetitive manual tasks and improve profitability by reducing costs and errors while increasing efficiency and productivity.

A multichannel inventory sync and order management solution can also help multichannel sellers stay organized, save time and money, and, ultimately, drive profitability.

2. Optimize the customer experience

It’s impossible to overstate the significance of the customer experience. According to a CallMiner report, US businesses lose over $35 billion annually in customer churn due to preventable CX issues.

Improving the customer experience can improve profitability by increasing customer loyalty and satisfaction, which results in repeat business and positive word-of-mouth referrals. Satisfied customers are more likely to pay a premium for a better experience, which can lead to increased revenue and profitability over time.

To optimize the customer experience, focus on automation, personalization, and delivering exceptional customer service across all touchpoints. Collecting and analyzing customer feedback can also provide valuable insights into elevating the customer experience and fostering customer loyalty.

3. Prioritize high-margin products or services

By focusing on products or services that generate higher profit margins, you can allocate resources more effectively and reduce costs associated with low-margin offerings. You can also optimize pricing strategies to maximize revenue and profitability.

Identify the products or services that generate the highest profit margin and focus on selling more of those items. This strategy could involve launching new product lines, increasing prices, or intensifying marketing efforts.

4. Focus on recurring revenue

You can allocate your resources more efficiently by creating a stable, predictable revenue stream less susceptible to market fluctuations.

You can also lower customer acquisition costs, increase customer lifetime value, and reduce churn. This focus leads to higher profitability and better understanding of customer needs and preferences.

You can also lower customer acquisition costs, increase customer lifetime value, and reduce churn. This focus leads to higher profitability overall and a better understanding of customer needs and preferences.

To create a predictable revenue stream, you can offer subscription-based services, implement loyalty programs, and provide high-quality customer service.

5. Keep an eye out for new ventures

Exploring new markets, products, or services can expand your business, diversify your revenue streams, and drive long-term growth and profitability.

Consider introducing a new product line, launching an existing product on a new ecommerce marketplace or platform, partnering with other businesses, networking with industry experts, or expanding into new geographic regions.

You can also leverage new technologies and trends to capture growth opportunities and increase your market share.

Conduct market research to identify potential growth opportunities and evaluate the viability of new ventures. This research includes analyzing consumer trends, competitor strategies, and industry forecasts. Evaluate the potential ROI and risk associated with each venture.