A business must achieve profitability in order to sustain its operations. It is impossible to imagine a business without profitability. Profitability measures the efficiency of the company.
Profitability differs from profit. Profit has a currency unit to measure while profitability is generally measured as a ratio of profit to revenue.
There are other ratios that can be used to determine profitability. Some of these ratios are Return of Assets (ROA), Return on Equity (ROE), Earnings per Share (EPS), Dividend per Share (DPS) etc.
There are two kinds of measuring profitability. It can be either in terms of accounting profits or in the form of economic profit.
1. Accounting Profit:
It is measures as the difference between the revenue earned from company’s operations and the total costs involved in brining the product to market. It doesn’t take into consideration the opportunity cost.
It gives an intermediate view of one’s business prospective.
e.g.) Suppose the company earns a revenue of $50,000 by selling its product and the total cost in manufacturing and selling the product in $40,000. Then the firm earns an accounting profit of $10,000.
2. Economic Profit:
While calculating the economic profit along with the regular accounting expenses, the opportunity cost involved in running the business is also deducted from the revenue to calculate the profit.
It gives a long-term view of your business perspective. Consistent negative economic profit may force someone to rethink on sustaining his current business activity.
e.g.) Suppose X earns $100,000 in revenue from his business and the accounting expenses are $70,000 for one year. If X had taken a job with another rather than managing his own business, he would have earned $50,000 in salary. Then the economic profit for X is ($100,000 - $70,000 - $50,000) -$20,000; which is actually a loss.