Profitability is the ability of a company to obtain a profit from the capital invested. Today we will learn about some profitability indicators to evaluate the performance of your company
Profitability represents the relationship between a company’s income and the amount of money that has been raised to obtain it.
Profitability is one of the business metrics that plays an important role in the life of a company:
- Ensures the survival of the company
- It allows the company to preserve its financial independence.
To calculate profitability, three types of profitability can be distinguished::
- Economic profitability.
- Financial profit
- Business profitability
What is the rate of profitability
There are many things you can measure in your company through numbers. No matter the area or size of the organization, it is always possible to have metrics that help you know what is happening inside and outside your organization.
The rate of return refers to a value that indicates the level of return generated based on the initial investment made, also known as capital. This rate is expressed as a percentage and is based on the principal and the annual return, which is the amount earned in one year.
What are profitability indicators?
Profitability indicators are those that are used to determine if the money invested in a company is working and to what extent. In other words, these indicators allow us to analyze the result in relation to the capital invested in the company.
The calculation of profitability indicators allows you to do two things. First, compare profitability between projects and between companies in the same sector. The second is to check if the capital invested has sufficient profitability to return it.
Importance of measuring profitability indicators
Entrepreneurs, company directors or business creators alike need to establish a measurement system to quantify their activity . Profitability indicators are part of this system and have their own characteristics. Its objective is to facilitate in-depth analysis of the results of the capital contributed to the company.
Examples of profitability indicators
These are some profitability indicators that you should measure to know more details about the behavior and health of your business.
1. Margin
The company’s margin is the difference between your sales of goods and/or services and the price at which you buy them.
It is a very good indicator for:
- Set sales prices according to purchases, Be able to determine when you will not make money or when you will lose it, Compare yourself to competitors and statistics in your industry.
To calculate gross margin, do the following calculation:
Gross Margin = Gross Profit / Net Income
In this case, as an investor you will find out how much the company earned before paying other charges such as taxes, etc.
The net margin, in turn, takes into account all of these charges. The calculation is as follows:
Net Margin = Net Profits / Net Income
If the margin is high, the investment will be better, because as a company you will have more benefits for the capital invested.
2. EBITDA. Earnings before interest, taxes, depreciation and amortization
EBITDA is an acronym in English (earnings before interest, taxes, depreciation and amortization) that means Earnings before interest, taxes, depreciation and amortization. It represents a company’s income before deductions for taxes, interest, depreciation and amortization, and provisions for fixed assets.
This profitability indicator is used to determine the economic results of a company in order to compare the wealth creation of different companies in the same sector.
When an EBITDA is positive, it reflects the profitability of a company (the company creates value) without taking into account the beneficiaries of this income.
EBITDA does not include financing, investments or taxes. On the other hand, a negative EBITDA is a reflection of an unprofitable company.
3. Return on investment
This indicator assesses the extent to which a company can generate profits through the mobilization of tangible and intangible resources . It also gives an important indicator of how the company uses its resources.
This is, of course, essential information to run your business in the smartest way possible.
Calculate the rate of return on investment before starting your business to estimate the rate of return on the capital you expect to invest.
Return on assets is calculated by dividing net income and total assets. The value of assets can be easily found on the balance sheet.
The net result is the difference between expenses and income.
The higher the return on investment, the more efficient the company is in using its resources. It also means that the company can increase its prices.
4. Asset performance
Return on assets is another profitability indicator that compares a company’s total assets with the amount it returns to its shareholders.
The formula to calculate this index is the following:
Return on Assets = (Net Income/Total Assets) x 100
The return on total assets ratio indicates the extent to which a company’s investments generate value, making it an important measure of a company’s productivity.
5. Total debt
The level of debt is important for any business, so you should analyze the repercussions of a bank loan or bond , which will require not only the repayment of the debt but also the payment of its interest.
To calculate the total debt of a company, the formula is the following:
Total debt = (third party capital/total assets) x 100
This profitability indicator shows us the weight of a company’s debt in relation to its equity.
6. Net cash
This is a fundamental indicator, it represents all the sums that can be mobilized at a given moment, or in the very short term.
Linked to working capital needs, it is a reliable indicator of the company’s financial health.
7. Price/earnings ratio
This profitability indicator is especially relevant when it comes to obtaining investors for the company, since it can reflect the market’s interest in betting on the company’s product or service.
Among market value indices, price to earnings is the best known and also the simplest, as it demonstrates the investor’s direct expectation of the asset. Basically, the price/earnings ratio shows how much an investor is willing to pay for each profit earned.
The formula to calculate this index is the following:
Price/Earnings Ratio = Asset Price/Asset Earnings
This type of metric gives investors confidence in what to expect when launching their proposal for a negotiation.
8. Balance point
This is another of the most important profitability indicators because it determines the level of turnover that must be achieved to reach the break-even point, and the threshold at which the activity is profitable.
Did you like learning about profitability indicators? Remember that these are just a few examples, and that many of the indicators you select will depend on your processes and industry.