Cambridge O Level Business Studies · Syllabus 7115 · Financial Information and Decisions
Profitability
What is Profitability?
A measure of profit expressed in relation to another financial quantity, most often revenue or capital employed, rather than as an absolute amount. Profitability answers whether the profit earned is adequate for the size of the business and for the capital invested in it, so a business can increase its profit and become less profitable at the same time if revenue or capital employed grows faster than profit does.
This definition is part of the Financial Information and Decisions chapter in Cambridge O Level Business Studies.
Profitability in context
Finance asks three different questions, and this chapter answers each one with a different tool. Can the business obtain the funds it needs? That is sources of finance. Can it pay what it owes on the day the payment falls due? That is cash flow, working capital and the liquidity ratios. Is it earning an adequate return on the money tied up in it? That is profit, the income statement and the profitability ratios. Treating those three questions as one question is the single most expensive error in this section of the syllabus.
Cash flow, working capital and profit measure three different things, and confusing them is the most common error in this chapter. A cash-flow forecast tracks expected cash receipts and payments each period, carrying the closing balance forward; working capital is current assets minus current liabilities, the finance available for day-to-day operations. Profit is revenue minus total costs over a period, and it is not cash, because a credit sale creates revenue today and cash only when the customer pays. Profitability relates that profit to revenue or capital employed, so a bigger profit on much bigger capital employed can mean the business has become less profitable.
Common mistakes with Profitability
- “Profit went up, so profitability went up.” Fix Only if revenue and capital employed did not rise faster. A business that doubles its profit while tripling its capital employed has become less profitable on the ROCE measure.
Questions students ask about Profitability
What is the difference between profit and profitability?
Profit is an absolute amount: revenue minus total costs over a period. Profitability relates that profit to another figure, usually revenue or capital employed, to judge whether the profit earned is adequate for the size of the business. A business can increase its profit and still become less profitable, if revenue or capital employed has grown even faster than the profit did.