Understanding how to calculate the rate of return and profitability of a business is critical for managers to clearly visualize the company’s financial situation. Managers commonly confuse these two terminologies, but they represent distinct aspects of the company. You need to know how to increase both if you want to ensure your business success.
If you have any questions about this subject, keep reading this publication. We will explain the concepts of these terms, their importance to the company, how to calculate them, and finally, which techniques are most effective in applying them. Check it out!
What is the difference between the two concepts?
First, it is important to understand that both are indexes that relate to the company’s net income. For this reason, they are constantly confused.
However, the result shows gains from different perspectives. Check out below what each of these concepts aims to achieve.
Rate of return
Rate of return is a percentage value that relates an initial investment and the speed at which a business gets its financial return.
Thus, if the rate of return is low, it means that the project invested is dispensable for the company; if its value is negative, it is causing losses, and finally, if its number is high, it is very beneficial to the company’s finances.
Profitability
This measure, also given as a percentage, shows how much a business effectively received in relation to the overall enterprise’s gains.
While the rate of return shows the return on investment, profitability shows all that has been achieved, taking into account projects, savings, sales, revenues, and other elements of the enterprise.
How important is it to understand the difference between the concepts?
Evaluating just one of these aspects will bring a poor overview of the business, giving a false impression that it is successful. That way, the controller will not have actual data on the enterprise’s gains, resulting in losses and even bankruptcy.
For example, it is possible that you have high profitability, but due to factors other than an investment. That way, you will not know if the project is profitable or not; it may be causing losses that you don’t know about, and that is a waste of capital.
Knowing how to calculate these indexes ensures the correct profit determination. This has a positive impact on the enterprise’s decision-making, since they will effectively provide the healthy growth of the company.
How to calculate rate of return and profitability?
Rate of return
Rate of return considers time as a fundamental variable. Usually it is calculated by relating the month and its corresponding cash flow. Another variable involved is the initial investment, and the formula is given as follows:
Rate of return = (net income in the period / initial investment) x 100%
Thus, let’s consider a business that required an initial investment of $400 million. Currently its monthly cash flow is about $25 million. In this instance, the monthly rate of return is given by:
Rate of return = (25/400) x 100%
Rate of return = 6.25%
A business is not profitable when this index is null or negative, which indicates that the investment has led to losses. On the other hand, the higher a business’s rate of return, the faster there will be a return on investment.
Profitability
In turn, to find a business’s profitability, you need to think in terms of turnover and net income for the period being analyzed. The relation is given by:
Profitability = (net income / total turnover) x 100%
Imagine, for example, that in one year a company had a turnover of $500 million. The gross income was $300 million and the net income $200 million. In this instance, the profitability would be:
Profitability = (200 / 500) x 100%
Profitability = 40%
This means that profitability depends much more on net income than on turnover, given that a very high turnover associated with low income lowers this index.
To better understand it, imagine the same situation, but in this case the income was just $100 million. Profitability would decrease to a half, even though the turnover remains the same.
How do you increase these indexes?
It is possible to act on these indexes so that they are increased or are more in keeping with management’s expectations.
Increasing profitability
These measures consist of making new investments whose returns can be measured. Here are some examples.
Segment the audience
Customers are the focus of any business, given that the revenue to sustain it comes from them. Markets are currently very crowded. In order to ensure that a particular audience will always acquire your brand’s products, you can develop goods and prepare a marketing action for a very specific consumer profile.
Create techniques to increase productivity
There is always room for maximizing employee productivity, whether by changing materials, exchanging staff, automating process, among other methods.
Negotiate prices with suppliers
Good negotiation can be exceptionally beneficial to the company. If you have a good relationship with a trusted supplier, try to negotiate lower prices with them. For example, you can offer a loyalty scheme to always acquire your raw material with them in exchange for a reduced price.
Maximizing profitability
Here we will show the main methodologies that increase the overall net income of the company; check it out.
Reduce operating costs
This strategy increases both the rate of return and profitability. Operating costs are those needed to keep the enterprise active, such as wages, electricity, etc. Reducing these expenses will result in an increase in the company’s profitability, not an increase in revenue.
Implement continuous improvements
There are numerous strategies and technologies that can be applied in the company: the biggest mistake a manager can make is to not continually seek improvements. These can be a better structural organization, computerization of the enterprise, use of new indexes that aid in decision-making, etc.
By using financial software, processes become faster, simpler and more accurate. With less time lost, there is more productivity, leading to gains in both rate of return and profitability.
Review sales prices
Customers’ taste, product values, and tax rates go through constant changes. Thus, the price of your goods or services should also be updated to keep up with the market.
Depending on the scenario, your products’ values could be higher, which would generate more profits, but it would also be feasible to reduce your prices in order to expand your customer network. This study will maximize profitability.
You can see that understanding how to calculate the rate of return and profitability allows you to have a real and transparent view of the business, and also ensures a more accurate and concrete decision-making. After reading this publication, you will know exactly how to use this knowledge to foster the company’s growth.
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