Profitability:

Definition:
Profitability is ability of a company to use its resources to generate revenues in
excess of its expenses. In other words, this is a company’s capability of generating profits
from its operations.
What Does Profitability Mean?
Profitability is one of four building blocks for analyzing financial statements and
company performance as a whole. The other three are efficiency, solvency, and market
prospects. Investors, creditors, and managers use these key concepts to analyze how well
a company is doing and the future potential it could have if operations were managed
properly.
The two key aspects of profitability are revenues and expenses. Revenues are the
business income. This is the amount of money earned from customers by selling products
or providing services. Generating income isn’t free, however. Businesses must use their
resources in order to produce these products and provide these services.
Resources, like cash, are used to pay for expenses like employee payroll, rent,
utilities, and other necessities in the production process. Profitability looks at the
relationship between the revenues and expenses to see how well a company is
performing and the future potential growth a company might have.
Example: There are many reports to use when measuring the profitability of
a company, but external users typically use the numbers reported on the income
statement. The financial statements list the profitability of the company in two main
areas.
The first signs of profit show in the profit margin or gross margin usually
calculated and reported on the face of the income statement. These ratios measure how
well the company is using its resources to generate profits.
The second sign of profit isn’t really a sign; it’s more like the real thing. The income
statement always reports the net income at the bottom of the report. This is often the true
sign of profitability because it shows external users the total amount of revenues that
exceeded the expenses during the period.

Standard Profitability:
Standard Profitability focuses on contribution analysis, following the flow of cost and
revenue funds through all stages of the process to determine where funds are coming
from, and where they are going.
A Standard Profitability and Cost Management model enables you to monitor and
control direct contribution data for your entire model. The input amounts, the flow of
cost and revenue, and the final destination of the funds can be tracked for both cost and
revenue to ensure the resources are used to best advantage, and profitability can be easily
demonstrated. Calculation results are posted to individual cost centers or accounts.
Data for the Standard Profitability model is housed in both Essbase
multidimensional databases and relational databases. You create the model in
Performance Management Architect, and define the hierarchy of accounts, activities and
operations within your organization using dimensions and dimension members. An
Allocation Type dimension is imported from Performance Management Architect. This
dimension is used to correctly allocate costs and revenue, and store direct allocations and
allocation genealogy.

Evaluating Profitability on Investment:

The following points highlight the top four methods of evaluating and ranking
profitability of investment projects. The methods are:
1. Pay Back Period (PBP) Method
2. Average Annual Rate of Return (AARR)
3. Net Present Value (NPV)
4. Internal Rate of Return (ARR)

Method # 2. Average Annual Rate of Return (AARR):

This method is based on the accounting concept of return on investment or rate of return.
It refers to the percentage of the annual net income earned on the average funds invested
in a project. The annual return of a project is the percentage of net investment in the
project.

It can symbolically be expressed as follows:

AARR = Average Annual Return/Average Investment in the Project x 100

The calculation of AARR consists of the following three stages:

1. To subs-tract initial investment from gross total income during the life of the project.
2. To divide net income by life years of the project for achieving per year average income.
3. To divide average annual income by initial investment and obtain return on
investment.
Accept or Reject Criterion:
AARR is compared with the cut off or the pre-determined rate of return. If AARR is more
than the predetermined rate of return, the project will be accepted otherwise rejected .

Merits of Average Annual Rate of Return:

1. This method is easy to understand and calculate.
2. It is based on accounting data that are always available.
3. It is contrary to the payback period method. It considers all the benefits arising
out of the proposal throughout its life.

Limitations of Average Annual Rate of Return:

In spite of the above merits, this method has the following limitations:
1. This method does not consider the time value of money. It gives equal importance to
all returns of the project arising throughout the whole period.
2. This method is unable to compare the projects of different time periods.
3. It is not based on cash flows but on accounting profit.
4. The use of average profit is misleading because it does not consider year-to-year
pattern of profits.

Method # 4. Internal Rate of Return (IRR) Method:

This method refers to the percentage rate of return implicit in the flows of benefits
and costs of projects. A. Marglin defines the internal rate of return (IRR), “as the discount
rate at which the present value of return minus costs is zero”. In other words, the discount
rate which equates the present value of project with zero is called IRR.
Thus, IRR is the discount rate which equates the present value of cash inflows with
the present value of cash outflows. IRR is also based on discount technique like NPV
method
Under this technique, the future cash inflows are discounted in such a way that
their total present value is just equal to the present value of total cash outflows. It is
assumed that the management has knowledge of the time schedule of occurrence of
future cash flows but not of the rate of discount.

IRR can be measured as:

A1/ (1+ r) 1 + A2/ (1 + r) 2 + A3 (1 + r) 3 + …..An/ (1+r) n-C=0
Where, A1, A2 A3, etc. are the cash inflows at the end of the first, second and third year
respectively. For example, if Rs.1,000 crores is invested in a project, they become Rs.1,200
crores at the end of the first year. Now the rate of return is calculated as follows:
C=A1/ (1+r) 1
Where, 1= Cash outflow or initial capital investment;

A1= cash inflow at the end of First year;

R= rate of return obtained from investment.
Thus, Rs.1,000= Rs.1,200/ (1+r)1
Or, 1,000+1,000 r = 1,200
Or, 1,000 r = 1,200-1,000
Or, 1,000 r = 20
r = 200/ 1, 00= 0.20 or 20%

If the return is obtained for more than one year, the rate of return can
be calculated as under:
C=A1/ (1+ r) 1 + A2/ (1 + r) 2 + A3 (1 + r) 3 + …..An/ (1+r) n
Accept or Reject Criterion:
A capital project is acceptable only when its internal rate of return (IRR) is more
than the desired rate of return. It the relative profitability of the first project is higher than
the second, the first will be superior and will be selected. If the net present values of two
alternative projects are given, the choice of the projects will depend on the discount rate.
This is illustrated in Figure 1 where the rate of discount is measured along the horizontal
axis and NPV on the vertical axis.
The curve AA1 depicts investment of project A and the curve BB1 of project B. The IRR of
project В is higher than that of project A because the discount rate Or is higher than Or 1.
At Or2, the IRR of both the projects is equal. But if the discount rate falls below Or 2 to Or3,
projects will be chosen because its NPV is higher by ba. Making a choice between two
projects on the basis of changes in the discount rate is called switching and re-switching.
Merits of IRR Method:
This method has the following merits.
1. This method does not consider the time-value of money.
2. The calculation of cost of capital is not an essential condition for using this
method.
3. It considers the cash flows occurring over the entire period of the project.

Limitations of IRR Method:

But this criterion has certain limitations:
1. Once a rate of return is assumed for the calculation of the profitability of a project, it is
not possible to change it.

2. It is difficult to calculate the rate of return on a long-gestation project which does not
yield benefits for a number of years.

3. If projects are mutually exclusive, this criterion favours that project which has a lower
capital cost than others Thus it cannot be applied to highly capital-intensive projects.

4. The use of IRR for public investment does not lead to correct decisions because the
definition of IRR implies that intermediate receipts and outlays are also discounted at the
internal rate. But it is not possible to discount intermediate benefits and costs of public
investment at the internal rate of return.

5. There are often such projects on which the entire investment outlay cannot be made in
the first period. It becomes difficult to calculate IRR in all such cases.

6. The IRR criterion is suitable for such investment projects which are wholly
independent of others. But public investments are not independent of each other. Often
they are alternatives. Therefore, it is difficult to make a choice between two alternative
investments on the basis of their alternative internal rates of return.
7. Layard points out the problem of capital rationing where projects cannot be selected
on the basis of ranking in order of rate of return. Such projects can only be selected on the
basis of their net present value.