A business’s rate of return and profitability are not the same thing. Rate of return has to do with time and the speed at which a business gets a return on its initial investment. Profitability, on the other hand, has to do with the contribution margin of a company and represents the financial resources that correspond to the gains of an activity.
These are two of the most important indices for a business, given that a venture that has no rate of return and/or profitability is usually forced to close its doors. So take a look at how to calculate if a business has a high rate of return and profitability and discover how to raise these indices.
How do you calculate rate of return?
Rate of return takes time into consideration as a fundamental variable. Usually the reference period is a month and its corresponding cash flow. Another variable involved in the calculation is the initial investment, and the formula is given as follows:
Rate of return = (net profits during the period /initial investment) x 100%
So, let’s consider a business that required an initial investment of R$ 400 million. Currently its monthly cash flow is roughly R$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 has no rate of return 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 the investment.
How do you calculate profitability?
To find a business’s profitability, on the other hand, you need to think in terms of total revenues and net profits for the period being analyzed. The formula to calculate this is as follows:
Profitability = (Net profits / total revenues) x 100%
Imagine, for example, that in one year a company has total revenues of R$500 million. The gross profits were R$300 million and the net profits were R$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 profits than on revenues, given that high revenues associated with low profits lower this index.
In other words, imagine the same situation, but in this case the net profits were just R$100 million. Profitability would fall by half, even though the revenues remain the same.
How can you increase these indices?
It’s possible to increase these indices so that they’re more in keeping with management’s expectations.
What these indices have in common is net profits, which influence cash flow and the size of revenues. A business should look towards automation to generate greater profits.
With the integrated use of technology, processes become simpler, faster, and more precise. With less time lost, productivity becomes greater and thus so do profits, leading to increases in the company’s rate of return and profitability.
Reviewing and redesigning processes is another way to achieve greater profitability and a higher rate of return, as is renegotiating with suppliers to reduce costs and increase profits.
Improving human resources management is another technique that, together with those listed above, will have a positive effect on these indices.
Rate of return and profitability are distinct concepts, and thus they are calculated in different manners. Through these calculations you’ll be able to get a better idea of your company’s situation, and then be able to make changes to elevate these indices.