Profitability:

Profitability refers to the efficiency of the business or it is the capability of a business to produce a profit
or return on investment based.

It has very importance for all ventures, investors and business men as it tells about the success or failure
of the running business. An investor should go for profitability analysis of the business rather than just
thinking about his profit. Because, profitability tells about the utilization of resource that may leads the
business towards the succession and losses. That’s why it is necessary to understand the profitability
analysis for all ventures, investors and business men.

Profitability Standard:

It is a quantitative measurement of the profit which a business or a company earns on the basis of the
investment.

It tells about the company or a business that how they make profit from the given investment in the
given time period.

Example:

Project 1 Project 2
1. Capital investment $500,000 $ 10,000,000
2. Yearly profit $10,000 $25,000
3. Annual rate of return 0.02 0.0025
It seems that profit get from 2nd project is maximum as compare to 1st. However, the return on
investment of project 1 is greater than 2 nd one. The profit is judge relative to that investment which is
earning that profit.

Minimum Acceptable Rate of Return:

It is defined as the rate of earning from the investment that should be acceptable for the investor who
had invest his money in the business. It is also known as minimum attractive rate of return.

It is abbreviated by MARR. The commonly use of profitability standard is known as MARR. The m ar is a
symbol of minimum annual rate of return which is used as a percentage per year. It is the minimum level
of return that investor is still attracted to invest to organization.

Methods for calculating the profitability:

Calculation of profitability of a business is very much important. There are different methodology of
calculating profitability which vary company to company.

The methods of calculating profitability which consider the time value of money include

Discounted cash flow rate of return

Net present worth

The methods of calculating profitability which don’t consider the time value of money include

Net return
Payback period

Rate of return on investment

The depreciation schedule that is used in evaluation is important for the methods of calculating
profitability which don’t consider the time value of money that’s why for convenience the straight-line
depreciation is usually used. The depreciation period which less or more same to the evaluation period
is used for the evaluations.

Evaluation Methods Percentage use

Large Companies Small Companies
Rate of return on investment 34 22
Payback period 52 43
Discounted cash flow rate of return 78 11
Net present worth 80 16

1. Return of Investment
It is defined as the ratio of profit to investment.
This profitability defines the ratio of any type of profit to any type of investment but usually
common for net profit to capital investment.
Mathematically,
ROI = N p/ Ŧ ……………………(1)

Where,
ROI = annual return of investment
Np = annual net profit
Ŧ = Total Capital investment
The net profit for a project may change yearly and doesn’t remain constant. Similarly, the total
capital investment may also change due to some additional investment. So in order overcome
the inconsistency we will go to take average ROI for entire project life, as given below
ROI = Np avg/ Ŧ ……………………………..(2)
N
(1 /N ) Σ j ( N p j)
ROI= N
… … … … … … ..(3)
Σ j=−b (Ŧ j)

Where,

N = evaluation period

Np,j = net profit in year j

-b = start up time year in which 1 st investment is made

Np avg = average value of net profit per year of the evaluation period

Hence, above three equation can be used to find out the ROI and may compare with the m ar value
supplied and if the answer value is equal or greater the m ar value then this project is offering the
acceptable rate of return and if the ROI obtained less than m ar value then the project is running on
losses.

2. Payback period
This profitability measure is defined as time period required for the total return to obtain the
capital investment.
The annual cash flow and the fixed-capital investments are used in the calculation of this
profitability
Mathematically,
V + Ax
PBP= … … … .(1)
Aj
Where,
PBP = Payback period in year
V = manufacturing fixed capital investment
Ax = non- manufacturing fixed capital investment
Aj = annual cash flow
V + Ax = fixed capital investment
This profitability indicates the time required to reach the fixed capital investment by the cash
flow. However the value of cash flow changes yearly so in order to overcome this situation a
particular year for cash flow is selected or the average value of cash flow is used as shown below
V + Ax
PBP= … … …..( 2)
A j avg
Or
V + Ax
PBP= N
… … … … .(3)
(1/ N )Σ j =1 ( A j )

The PBP can be calculated by either of these three equations and for acceptable project the
PBP value should be less or equal to the reference value therefor the value obtained from the
equation should be compared with the minimum acceptable rate of return.
Because V + Ax is approximately equal to O.85 Ŧ and (Aj)ave is equal to Np_awe + dj,ave = marT + 0.85T/N, ''
O .85 Ŧ O.85
PBP= =
0.85 Ŧ 0.85
mar Ŧ + m ar +
N N
3. Net Return
The profitability measure the amount of cash flow that is over and above to meet the minimum
acceptable rate of return and recover the total capital investment.
Mathematically,
Rn =Σ Nj=1 ( N p j+ d j +rec j )−Σ Nj=−b Ŧ j−mar N Σ Nj=−b Ŧ j
where ,