Profitability is an essential measure that reflects the ratio of profits made to capital invested. It is a key figure that provides insight into the returns of a business. The first part of the term profitability refers to the word return. Calculating profitability is important to get a clear picture of a company’s health. Stakeholders in this calculation are investors and shareholders. It is especially important for shareholders to know whether a company is growing and/or making a profit in the long run, since this group is paid from dividends (=profit distribution from a company). If it turns out that a company does not make a profit (in the long term), it is not interesting for shareholders to invest in a company.
How do you calculate profitability?
There are several ways to calculate profitability. Below are the formulas of profitability of total assets, equity and debt:
RTV: (operating income / average total capital employed) x 100%;
REV: (earnings after interest and taxes / average invested equity) x 100%;
RVV: (interest paid / average debt invested) x 100%.
Why is profitability important?
- Profitability and Growth: Profitability is the key to profitability and growth. It enables companies to generate the financial resources needed to expand their operations, enter new markets, develop new products or services, and invest in research and development. Healthy profitability is attractive to investors and enables companies to attract capital for further growth.
- Financial stability: Good profitability is essential to a company’s financial stability. It enables companies to repay debt, fund working capital and maintain sufficient cash to meet their obligations. Solid profitability reduces the risk of financial distress and increases a company’s resilience in times of economic challenges.
- Investor confidence: Investors are looking for profitable companies in which to invest their money. Positive profitability is an important measure for investors to assess whether a company is attractive for investment. It demonstrates a company’s efficiency and effectiveness in generating profits, which increases investor confidence and facilitates access to capital.
- Decision-making and strategy development: Profitability is a valuable tool for making business decisions and developing strategies. It provides insight into which products, services, markets or customers are most profitable, allowing companies to effectively allocate resources and focus their efforts on areas with the greatest potential for profitability.
Profitability in practice
Investments are made with the intention of being earned back and, in addition, to yield maximum returns. The following two examples show why calculating profitability is important and why it should be given due consideration:
- A factory buys a (new) production machine;
- A farmer buys a milking robot to milk cows in an automated way, reducing manual labor and therefore fewer workers.
Such purchases are major investments for a company. The cost in some cases can run into the millions. In general, it takes five to 10 years for most businesses to turn a profit. This directly indicates the essence of profitability. By calculating this, a company sees whether an investment will yield a return (result) in the strategic term. Profitability can be divided into two items, namely profitability on equity and profitability on debt. If a company has a REV (=return on equity) of 20%, this means that €0.20 is earned on every euro invested in the company. In other words; every euro put into the company earns €0.20. If a company has an RTV (=rentability total assets) of 10% and then uses this to attract new loan capital at an interest rate lower than 10%, the company earns on this loan capital. In addition to profitability, solvency and liquidity are also important measures of a company’s health.
