Profitability refers to the benefit, profit or gain that was obtained from a resource or money invested, ie. a measure of the efficiency of a company in using its financial resources. A company is efficient if it is not wasteful.

Usually companies use financial resources for profit searching. These resources are, firstly, the capital (shareholders’ contribution) and, secondly, other debt (by creditors).

To this we must add the reserves: the benefits that the company held in previous years, in order to finance themselves (these reserves, along with capital, constitute the «Equity»). Profitability is usually expressed in percentages. If a company uses very large financial resources but gets small profits, will think that it has «wasted» funds or, in other words, has used many resources and gained little benefit to them. Conversely, if a company has used few resources but has made a profit relatively high, we can say that it has used their resources well. For example, a very small company, despite its limited resources, may be very well run and get high profits.

The risk-return dichotomy: In investing, future profitability is uncertain. It can be big or modest, or may be not and can even mean losing the capital invested. This uncertainty is called risk. The only reason to choose an investment with risk instead of a safer savings alternative is the possibility of obtaining a higher return from it.

– At equal risk conditions, we must choose investments with higher returns.

– At the same conditions of profitability, we must choose the less risky investment. Thus, the more risk that is assumed by an investment, more profit is required to make it attractive to investors. Similarly, the more profit desired, the more risk has to be assumed.

Profitability Measures: There are several possible measures of profitability, but all have the following form:

Profitability = Economic result / investment

An investment is the better when higher profits are generated and fewer resources are required to obtain these benefits (efficiency).

The two most commonly used measures of profitability are:

1. Return on assets (ROA): this represents, from an economic perspective, the investment performance of the company, regardless of the funding source or origin.

It is calculated using economic profit as a measure of profit and total assets as a measure of resources used:

ROA = EBIT / AT Where: BE = Economic Profit (before interest and taxes)

AT = Total assets Sometimes it is referred as Return on investments (ROI).

2. Return on Equity (ROE): It is the performance of the business equity. It is calculated with net income (after taxes) and Equity as the proxy of the financial resources used in the investment.

ROE = Net income/ Equity

Also, it is called net profit or return on equity. Indeed, one of the obligations of a company is to pay interest on the debt and the taxes. The relationship between the two types of return will be defined by the concept known as financial leverage since a financial structure in which foreign capital exists will act as an amplifier of financial profitability instead of economic profitability if the latter exceeds the average cost of debt.

Otherwise, when the profitability is lower than the cost of debt (foreign capital into the company pays less than its costs), this produces the opposite effect: the debt erodes or reduces equity profitability.