Understanding the difference between profitability and rate of return
Every entrepreneur seeks to earn money when opening a business. This is obvious. The terms profitability and rate of return and often considered synonymous by entrepreneurs and businessmen. But are they really? The answer is no.
It’s essential that the financial and management areas of a firm have a perfect understanding of the difference between these two concepts so that the entrepreneur will be better able to manage the business.
It’s important to understand that these two concepts mean different things. If you want to learn more about this subject, then continue reading this text and eliminate your doubts once and for all!
Find out more about profitability
A company’s profitability, as the name suggests, has to do with its profit. Or in other words, a venture is considered to be profitable depending on the relationship between its net profit and total revenues.
The basic formula for calculating the profitability of a company is as follows:
Profitability = Net Profit x 100 ÷ Total Revenues
Remember that the net profit is the total profit of a company after you deduct expenses, and total revenues are the total amount of money that the business receives. Profitability is an indicator of operational efficiency, whose result is given in the form of a percentage.
Find out more about the rate of return
The rate of return, on the other hand, is a business’s capacity to generate revenue. Unlike profit, which deals with the revenue that the business has already generated, this indicator refers to investments in products. In other words, it deals with the capacity of a business to generate profit by investing in a given product.
Thus to discover a product’s rate of return, you need to analyze its previous sales. If the investment in it is less than the revenues from its sales, then it’s considered to have a positive rate of return. And for a venture to have a positive rate of return, it has to have greater revenues than its total fixed costs and other expenses.
This indicator is also given in terms of a percentage. The way to calculate the rate of return of a venture is as follows:
Rate of Return = Net Profit x 100 ÷ Investment
Understanding the difference in practice
The main problem with the confusion between these two concepts, however, is the fact that profitability and a positive rate of return don’t necessarily go together. Profitable companies don’t always have a positive rate of return and vice-versa.
For example: many people think that a large number of sales automatically implies that the merchandise in question is profitable and has a positive rate of return. And this is a mistake: even though the product may have a positive rate of return, given that it doesn’t spend much time in storage, it won’t necessarily be profitable.
This is because profit takes into account the price of the product. In this case, if the price is below the market price, it’s natural that it will have greater sales than the competitors’ products. However, if this price is well below the ideal price, in contrast to the business expenses, it won’t generate profit for the company. The product will have a positive rate of return, but won’t be profitable.
After reading this, you can see how unquestionably important it is to consider both the profitability and rate of return of your company in order to know where and how to invest. Focusing on just one of these aspects may be fatal to your firm’s budget, and confusing these two concepts may hide serious problems with your business.