Profitability rate: calculation and definition

The profitability rate is a key performance indicator for all businesses.

In this article, we’ll look at what the profitability ratio is, which is also sometimes referred to as the “net margin ratio”, “profit margin” or “business profitability ratio” in accounting, and give you the formula for calculating it.

Then we will discuss what the profitability rate can do for businesses, and finally, we will compare the two concepts of profitability and profitability, which are sometimes confused.

What is the rate of profitability?
Here is the definition of profitability given by the INSEE: “Profitability is the ratio between profit and production. The profitability rate therefore relates the net accounting result to the turnover excluding taxes (RNC/CAHT).”

In economic and accounting terms, profitability remains one of the main criteria that investors like to take into account to gauge the performance and wealth creation of companies, as it expresses their ability to generate income from the financial resources they use.

Thus, companies with a high rate of profitability over the long term are the ones that interest investors and shareholders most, simply because they ensure constant revenues over time, and therefore a certain security in terms of investment.

Profitability is expressed as a rate/ratio between a given volume of activity and a given volume of results.

How to calculate the profitability rate?
The profitability rate is calculated using the following formula:
Profitability rate = (Net income)/(Sales excluding tax)

As a reminder, the net result is obtained by adding the operating result to the financial result and to what is called in accounting terms the exceptional result.

The turnover corresponds to the total sales of products, goods or services that a company makes during a given accounting period.

Here is a simple example to illustrate the calculation of a company’s profitability rate:

Company X has a turnover of 2 million euros and a net result of 40,000 euros.

Its rate of profitability is therefore calculated as follows:

40 000 : 2 000 000 = 0,02

Expressed as a percentage, this gives 2%.

This 2% ratio shows that the company is making a profit that corresponds to a small percentage of its sales, but it in no way indicates the profitability level of the company’s operating cycle alone.

To judge the level of performance of a company’s profitability rate, it must be compared to that of its main competitors. If your profitability rate is equal to or higher than the average of the companies in your sector of activity, this is a good result.

The higher it is, the more interested potential investors will be. The fact that your profitability rate is steadily increasing from year to year is also a positive.

The interest of companies in calculating their profitability rate
Since the profitability rate is, by definition, a ratio, experts never analyze it in isolation.

To begin with, you must take into account the rates calculated in past years, over several years, and you must also consider the average profitability rate of your company’s sector of activity to draw conclusions about this performance indicator.

Thus, the profitability rate is an accounting tool that allows companies to assess their business activity and its evolution over time.

But keep in mind that this index is far from providing a complete description of a company’s performance.

In the context of a projected income statement, for example, the concept of profitability can also be used to analyze the performance of a future project.

In this case, only the operating result is taken into account, while the financial result, which includes financial income and expenses, and the extraordinary result are not taken into consideration.

As a reminder, the operating result corresponds to the gross operating surplus of a company.

Other profitability indicators
The other indicators used to measure the profitability of companies focus mainly on the so-called “normal” activity of the company.

This is where the concept of economic profitability comes in, which we will discuss later in this article.

With the economic profitability, you will be able to measure your performance in relation to the means made available to your company, and not in the light of your turnover.

The so-called economic margin rate is also used to measure profitability.

In this case, the calculation is made by analyzing the evolution of the margin on the basis of the intermediate management balance table, but also by making a comparison with companies in the same sector of activity.

In trading companies, this margin rate is referred to as the “trade margin”, while companies that manufacture finished products use the term “production margin”.

Profitability Vs. Profitability
Along with the notion of profitability that we analyzed above, profitability is another privileged indicator to measure the performance of companies. But what is the difference between them?

Profitability is defined as the ratio between the result obtained and the resources used to obtain it.

But in the field of finance, there are two types of profitability: economic profitability and financial profitability.

Let’s first take a look at what economic profitability consists of.

Economic profitability, which corresponds to the English term “return on capital employed”, abbreviated as “ROCE”, indicates the net result generated by a company, in relation to its economic assets, as follows:

Economic profitability=(Net income)/(Economic assets)

Financial profitability, which translates into “return on equity”, abbreviated as “ROE”, corresponds to the profitability of a company’s equity, and is expressed as the following ratio

Financial profitability=(Net book income)/(Equity)

Thus, the main difference between the concepts of profitability and profitability is in the denominator: the turnover in the first case and the economic assets or equity in the second case.

The conclusions and interpretations that you can draw from these two types of indicators are therefore not the same.

On the one hand, the calculation of the profitability rate will allow you to determine whether your company’s activity is capable of generating results or margins based on the turnover achieved.

On the other hand, the calculation of the rate of return will allow you to verify that the means made available to the company are sufficient and that the profits generated by the company correctly remunerate the invested capital.

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