Definition: Profitability is ability of a company to use its resources to generate revenues in excess of its expenses. In other words, this is a company’s capability of generating profits from its operations.
What Does Profitability Mean?
Profitability is one of four building blocks for analyzing financial statements and company performance as a whole. The other three are efficiency, solvency, and market prospects. Investors, creditors, and managers use these key concepts to analyze how well a company is doing and the future potential it could have if operations were managed properly.
The two key aspects of profitability are revenues and expenses. Revenues are the business income. This is the amount of money earned from customers by selling products or providing services. Generating income isn’t free, however. Businesses must use their resources in order to produce these products and provide these services.
Resources, like cash, are used to pay for expenses like employee payroll, rent, utilities, and other necessities in the production process. Profitability looks at the relationship between the revenues and expenses to see how well a company is performing and the future potential growth a company might have.
There are many reports to use when measuring the profitability of a company, but external users typically use the numbers reported on the income statement. The financial statements list the profitability of the company in two main areas.
The first signs of profit show in the profit margin or gross margin usually calculated and reported on the face of the income statement. These ratios measure how well the company is using its resources to generate profits.
The second sign of profit isn’t really a sign; it’s more like the real thing. The income statement always reports the net income at the bottom of the report. This is often the true sign of profitability because it shows external users the total amount of revenues that exceeded the expenses during the period.