Profit and Profitability: Understanding the Differences and Their Importance

Profit is the foundation of any business, driving its operations and growth. But how do we measure profit effectively and compare it across companies? There are two approaches: absolute profit, calculated as total revenue minus total expenses, and profitability, which examines profit relative to revenue. In this article, we will explore:

1. What is profitability, and how does it differ from profit?
2. Why is profitability more crucial?
3. Examples of profitability in action.

What's The Difference Between Profit and Profitability?

Let's start with profit. Profit is simply the amount left after subtracting expenses from revenue (Profit = Revenue - Expenses). While revenue is earned through services or product sales, generating it typically involves expenses like wages, equipment, and marketing. Profit, therefore, provides an absolute measure of how much extra money a business earns at the end of a period.

Profitability, however, is a relative measure. It looks at profit as a percentage of revenue, providing a way to compare businesses of different sizes. This percentage gives insight into how efficiently a company is generating profit from its resources. While both profit and profitability use the same numbers, they serve vastly different purposes—profit measures raw earnings, while profitability measures efficiency and sustainability.

Why is Profitability More Important?

Profit alone can be deceptive. Imagine we have two companies and company A makes $2,000,000 revenue and has costs of $1,800,000, hence a profit of $200,000. Company B makes $1,000,000 of income and has expenses worth $800,000, and therefore, also making $200,000 profit. Both companies make the same profit but are they equally profitable?

No, because one company has to spend far more money to generate that level of profit and is therefore susceptible to any increases in cost. To illustrate this, say companies A and B respectively spent $400,000 and $200,000 on gas for trucks in the previous year and gas prices rose 10% in the second year. All other things being equal, company A's costs would rise by $40,000 and profit would then be $160,000, whereas company B's costs would rise by $20,000 and profit would be $180,000. Company B is more resilient to cost changes than company A because of its higher profitability.

Understanding both profit and profitability is essential for assessing a company's financial health, sustainability, and ability to weather changes in costs.

Profitability Examples

The next article in this series will go into detail about a plethora of ratios that you can use to analyze profitability. However, to illustrate profitability we are going to look at the Gross Profit Margin of Amazon using data from Amazon's Income Statements. Firstly, what is the gross profit margin?

Equation: Gross profit margin = Gross Profit / Revenue

Gross profit is calculated by subtracting Cost Of Goods Sold (All the variable costs including direct labour, materials, packaging, and others) from Revenue. Luckily Income Statements show gross profit on them so you won't have to calculate it.

What we see is that Amazon's gross profit margin has grown steadily over the last 10 years. This is driven by Amazon's disruption in the retail industry by their innovative business model. They have driven revenue growth by offering next day delivery (and same day delivery in some places) of almost any good you need and branching into live streamed entertainment with Prime Video. Amazon has cut costs at the same time by automating many services (such as warehouse picking) and manufacturing a lot of their own goods at a lower price than they could buy them for. From an investment perspective, they are becoming more monopolistic in the industries they serve which gives an investor confidence in their ability to keep growing as a company.

Rounding Up

Profitability is the relative measure of profit. It compares how much profit a company makes compared with its overall revenue and costs. By so doing, it enables you to have a more holistic view of how well a company is doing. There's no better way to learn than to practice yourself. Financial Modeling Prep gives you access to the financial statements of all SEC listed companies with the SEC Filings API. Download the income statement of your favourite company and calculate its gross profit margin. The next article in this series, will help you understand the other ratios that can be used to measure profitability.