What is profitability and why is it more important than profit?
Profit, profit, profit… The core of any business and the reason anyone would start a business in the first place. So how do we measure profit and compare it to other companies? You could look at the absolute value of profit, total revenues minus total expenses. Or, you could look at the relative profit, how much profit is made compared to total revenue. The latter is known as profitability. In this article, we will explore:
1. What is profitability and how is profitability different to Profit?
2. Why is profitability more important?
3. Some profitability examples
What is Profitability & How is it Different From Profit?
First, let's look at profit. As we mentioned in the introduction, profit is most simply defined as what is left when you deduct expenses from revenue (Profit = Revenue - Expenses). Revenue, or income, is generated by delivering services or selling products. However, generating revenue is typically not a free exercise, it comes with lots of expenses, or costs, such as employee wages, equipment, and marketing to name a few. So, profit is an absolute measure of how profitable a business is. It tells you the dollar amount of how much extra money is left for owners at the end of a period.
On the other hand, profitability is a relative measure of how profitable a business is. What this means is that calculating profitability removes the raw absolute amount of the profit, revenue, and expenses and looks at those in percentage terms. By doing so, you can look at companies of different sizes and look at their levels of profit side by side. Generally, a company with higher profitability is more efficient, in as much as they are generating a higher percentage of profit for each dollar of input expended. So yes, profit and profitability are very much related, they use the same numbers but they are vastly different in their uses.
Why is Profitability More Important?
Profit alone can be deceptive. Imagine we have two companies and company A makes $2,000,000 revenue and has costs of $1,800,000, hence a profit of $200,000. Company B makes $1,000,000 of income and has expenses worth $800,000, and therefore, also making $200,000 profit. Both companies make the same profit but are they equally profitable?
No because one company has to spend far more money to generate that level of profit and is therefore susceptible to any increases in cost. To illustrate this, say companies A and B respectively spent $400,000 and $200,000 on gas for trucks in the previous year and gas prices rose 10% in the second year. All other things being equal, company A’s costs would rise by $40,000 and profit would then be $160,000, whereas company B’s costs would rise by $20,000 and profit would be $180,000. Company B is more resilient to cost changes than company A because of its higher profitability.
The next article in this series will go into detail about a plethora of ratios that you can use to analyze profitability. However, to illustrate profitability we are going to look at the Gross Profit Margin of Amazon using data from Amazon’s Income Statements. Firstly, what is the gross profit margin?
Equation: Gross profit margin = Gross Profit / Revenue
Gross profit is calculated by subtracting Cost Of Goods Sold (All the variable costs including direct labour, materials, packaging, and others) from Revenue. Luckily Income Statements show gross profit on them so you won’t have to calculate it.
What we see is that Amazon’s gross profit margin has grown steadily over the last 10 years. This is driven by Amazon’s disruption in the retail industry by their innovative business model. They have driven revenue growth by offering next day delivery (and same day delivery in some places) of almost any good you need and branching into live streamed entertainment with Prime Video. Amazon has cut costs at the same time by automating many services (such as warehouse picking) and manufacturing a lot of their own goods at a lower price than they could buy them for. From an investment perspective, they are becoming more monopolistic in the industries they serve which gives an investor confidence in their ability to keep growing as a company.
Profitability is the relative measure of profit. It compares how much profit a company makes compared with its overall revenue and costs. By so doing, it enables you to have a more holistic view of how well a company is doing. There’s no better way to learn than to practice yourself. Financial Modeling Prep gives you access to the financial statements of all SEC listed companies for you to play around with. Download the income statement of your favourite company and calculate its gross profit margin. The next article in this series, will help you understand the other ratios that can be used to measure profitability.