How to work out the profitability of a business

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

02 February 2020 

Many business people confuse profit with profitability. Profit is the amount of money that remains after all costs have been paid; while profitability is the rate of generating the profit.

One way of measuring profitability is to compare the profit to the value the assets that were used in generating it. To illustrate, consider a small business that is selling fast-moving goods (milk, bread, salt and other groceries).

The gross profit margins for such goods is quite small – 5 per cent of the retail price, or even lower. That is, the shop owner buys something at Sh95 and sells it at Sh100.

Now suppose the total costs of running this business is Sh100,000 per month – rent, utility bills, salaries etc. Assuming the 5 per cent gross profit margin, it turns out that, to break-even, the monthly sales of the shop must be at least Sh2 million. (5 per cent of Sh2 million is Sh100,000).

This works down to about Sh67,000 per day. Not so scary, after all! But the important thing to note is that, even with this much money going to the bank daily, the business is not making any profit. It is just meeting its operating costs.

Suppose the sales are Sh70,00 daily; this comes to about Sh2.1 million per month. Since the shop breaks-even at Sh2 million, it is easy to see that the profit is Sh100,000 monthly.

We may set aside about Sh30,000 for income tax and that would leave Sh70,000 for the owner. The actual tax amount figure may differ depending on the registration nature of the business.

So, this business is making a profit of Sh70,000 per month, but what is its profitability? To get the answer, we need to find out the value of its assets. We may realistically assume that it is operating from rented premises and, in that case, the biggest asset is the stock in the shop. And so, the question is: how much should such a shop hold?

The answer depends on the mode of operation of the business. In the groceries sector, many suppliers make daily rounds delivering goods to the retailers. In such a case, the shop needs to only hold one day’s worth of stock. But to be on the safe side, the owner may decide to keep two days’ stock – just in case the delivery vehicle breaks down on the way.

Two days of sales is worth Sh140,000; but let’s not forget that this already has a gross mark-up of 5 per cent. So, the purchase value of the stock required is Sh133,000. Anything more than this will be unnecessary.

Therefore, this is a business valued at just Sh133,000 and it is making a profit of Sh70,000 every month. The monthly profitability is 53 per cent; the annual figure is 632 per cent!