- December 24, 2015
- Posted by: Jack Hudson
- Category: Finance
Managers, shareholders, employees, bankers, etc … are aware that revenues are fundamental to the proper functioning and development of your business. The performance of a company can be assessed in different ways, and can be expressed by the rate of sales growth by market share, competitive position … However, behind all this is the idea that the business must be profitable i.e. the profitability of the company. And what does this imply?
You can define the profitability of a company and its ability to produce a profit. The profitability of a company therefore can be assessed by comparing the end result and the value of the means used to get there. Profitability can be distinguished financial profitability and economic returns, in which two concepts are of vital importance: efficiency and effectiveness.
The effectiveness is the ability of a company to achieve its objectives, and efficiency is the ability of a company to achieve these objectives but performing it so that its resources are optimized. Profitability can be analyzed from the point of view of the employer (profitability) and the point of view of shareholders (financial performance).
The profitability measures the return on invested capital and only determined before taxes. The viability is indicating to us from an economic point of view if the company is profitable. The economic viability of a business varies with the level of activity, improved inventory management; reduced payment terms of customers or permit capital renewal improve profitability.
The financial return measures the return on equity. The shareholders generally and is determined after tax. Financial returns vary depending on the level of indebtedness of the company. Ways to improve this profitability can come by increasing the income of the company or by modifying the structure of its financing and increasing the proportion of loans on investment (increase its debt ratio).
When profitability is higher than the interest rate charged by banks (loans), this debt can improve financial returns. This means that it is more advantageous for the company to finance part of its investment with loans instead of resorting to contributions from shareholders (equity). This is known as debt leverage.
However when profitability is lower than the interest rate, the debt results in a decrease in profitability. In this case, it is preferable to use equity rather than bank loan.