What determines a business profitability?
Your profitability in business is your revenue from operations, less your expenses. The greater the result, the more profitable you are. The factors affecting profits include demand for your products, the cost of making them, the general economy and the competition you face.
Those determinants include firm size, liquidity, solvency, financial leverage, and financial adequacy while the financial performance is evaluated by three different ratios: return on assets (ROA), return on equity (ROE), and return on sales (ROS).
Profitability is the primary goal of all business ventures. Without profitability the business will not survive in the long run. So measuring current and past profitability and projecting future profitability is very important. Profitability is measured with income and expenses.
Key Takeaways
The most direct factor that affects profit margins is your net or gross profit. One of the easiest and fastest ways to adjust profit margins is to adjust the sale price of a product or service.
- Net Sales – Cost of Goods Sold = Gross Profit.
- Gross Profit – (Operating Costs, Including Selling and Administrative Expenses) = Operating Profit.
- (Operating Profit + Any Other Income) – (Additional Expenses) – (Taxes) = Net Profit.
In literature, different determinants of productivity are studied such as size, risk, net interest income. One of the important variables which is said to positively relate to the productivity is size of banks.
An increase in costs will decrease profits; this could include labour costs, raw material costs and cost of rent. For example, a devaluation of the exchange rate would increase the cost of imports, and therefore companies who imported raw materials would face an increase in costs.
This theory of profits explains that economic profits arise because of successful innovations introduced by the entrepreneurs. It has been held by Joseph Schumpeter that the main function of the entrepreneur is to introduce innovations in the economy and profits are reward for his performing this function.
Profitability is a measure of an organization's profit relative to its expenses. Organizations that are more efficient will realize more profit as a percentage of its expenses than a less-efficient organization, which must spend more to generate the same profit.
A good metric for evaluating profitability is net margin, the ratio of net profits to total revenues.