What Does Cost effectiveness Mean
We explain what profitability is and the types of profitability that are distinguished. In addition, its indicators and its relationship with risk.
What is profitability?
When we talk about profitability, we refer to the ability of a given investment to yield higher returns than invested after waiting for a period of time. It is a fundamental element in economic and financial planning , since it implies having made good choices.
There is profitability, then, when a significant percentage of investment capital is received , at a rate considered adequate to project it over time. The profit obtained through the investment will depend on this and, therefore, will determine the sustainability of the project or its convenience for the partners or investors.
A common distinction is made between economic, financial and social profitability:
- Economic profitability. It has to do with the average profit of an organization or company with respect to all the investments it has made. It is usually represented in percentage terms (%), based on the comparison between the overall investment and the result obtained: the costs and the profit.
- Financial profit. This term, on the other hand, is used to differentiate from the previous one the benefit that each partner of the company takes, that is, the individual ability to obtain profit from their particular investment. It is a measure closer to investors and owners, and is conceived as the relationship between net profit and net worth of the company.
- Social profitability. It is used to refer to other types of non-fiscal profit, such as time, prestige or social happiness, which are capitalized in ways other than monetary profit. A project may not be profitable economically but it can be socially.
See also: Financial statements
Profitability indicators
Profitability indicators (or profitability) in a business or a company are those that serve to determine the effectiveness of the project in generating wealth, that is, they allow controlling the balance of expenses and benefits , and thus guarantee the return.
The profitability indicators are:
- Net profit margin. It consists of the relationship between the company's total sales (operating income) and its net profit. The return on assets and equity will depend on this.
- Gross profit margin . It consists of the relationship between total sales and gross profit, that is, the remaining percentage of operating income after discounting the cost of sale.
- Operating margin. It consists of the relationship between total sales, again, and operating profit, which is why it measures the performance of operating assets for the development of its corporate purpose.
- Net return on investment. It is used to evaluate the net profitability (use of assets, financing, taxes, expenses , etc.) originated on the assets of the company.
- Operational return on investment. Similar to the previous case, but assesses operational profitability instead of net profitability.
- Return on equity. Evaluates the profitability of the owners of the organization before and after facing taxes .
- Sustainable growth. It aims for the growth in demand to be satisfied with a growth in sales and assets, that is, it is the result of the application of sales policies, financing, etc. of the company.
- EBITDA. This is known as the net cash flow of the company before taxes and financial expenses are paid.
Profitability and risk
The risk of an asset or a company depends on its ability to generate return , that is, to provide profits and comply with all the agreed financial terms, once its expiration date has been reached.
Thus, it is the product of an evaluation of the probability of payments: the greater the possibility of non-payment or non-compliance with the contractual terms, the greater the risk margin assigned.
This indicator is not only used to evaluate the economic profitability of companies , but also of countries. The risk margin of each entity will depend on the solvency that they present to their creditors and the guarantees that are incorporated into the title.