Financial Management Objectives (3) Profitability
Profitability is a basic goal for all institutions, a necessary for their survival and continuity, a goal that investors aspire to, and an indicator that creditors care about when they deal with the institution, and it is also an important tool for measuring the efficiency of management in using the resources at its disposal. Therefore, we find that a great effort from the financial management in the institution is directed primarily towards the optimal use of available resources in order to achieve the best possible return for its owners, the value of which is not less than the return that can be achieved on alternative investments that are exposed to the same degree of risks.
Institutions work to achieve their profitability goal through two decisions:
- Investment Decision
- Financing Decision
The following is a description of each of these decisions:
An investment decision is a decision regarding how an organization will use the resources available to it to acquire its various types of assets.
The impact of the investment decision on profitability appears through the optimal distribution of the resources available to the institution on the various types of assets in a manner that balances the appropriate investment in each item of assets without an increase that leads to disruption of resources, and without a shortage that leads to missed opportunities, in order to enable the institution to achieve the best possible return without sacrificing liquidity.
Financing decision is the decision on how to choose the sources from which the funds necessary for the institution will be obtained to finance the investment in its assets.
The impact of the financing decision on profitability is reflected by arranging sources of funds (from debts and owners’ rights) in a way that enables project owners to obtain the largest possible return, by taking advantage of the advantage of expanding fixed-cost borrowing, but without exposing them to the risks that can result from exaggeration. in borrowing.
The difference between Profit and Profitability concepts
There is a fundamental difference between the concept of profit and profitability, this may explained as follows:
1. The concept of Profit
There are two concepts of profit, namely:
Economic concept of profit
It means the amount of change in the net worth of an economic unit during a given time period.
Accounting concept of profit
It means the difference between the income earned by the economic unit during a certain period of time and the expenses incurred by that unit during that period to achieve that income.
This will be limited to talking here about the accounting concept of profit.
Sub-concepts of the accounting concept of profit
Within the accounting concept of profit, there are two sub-concepts:
Net Operating Profit
Net operating profit means the difference between sales during the period of time from the main business of the organization and the costs of such sales, plus general and administrative expenses, selling and distribution expenses, without including interest paid or other income and expenses and taxes.
Therefore, the net profit from operations can be calculated through the following steps:
Total Operating Profit = Net Sales – Cost of Sales
Then to extract the net operating profit, the following is subtracted from the total operating profit:
Net Operating Profit = Total Operating Profit – (General and Administrative Expenses, Selling and Distribution Expenses before interest)
This concept of profit is considered the best concept that expresses the efficiency of the institution in carrying out its basic activity, and the profitability of its operations. It is also considered an appropriate basis for comparing the performance of different institutions in terms of activity, size and age, as well as comparing the performance of different years for the same institution.
Net Profit after Tax (Comprehensive Profit)
The concept of net profit after tax means the profit resulting from the difference between the organization’s income from all sources (sales and other sources) and whatever costs (sales costs) and any other costs not related to operations (such as the loss of selling an asset) and after deducting taxes as well.
It is possible, based on the net profit of operations, to get this profit as follows:
Net Profit (Comprehensive) = (Net Operating Profit + Interest + Investment Income) – (Loss on sale of Assets + Tax)
2. The Concept of Profitability
Profitability is the relationship between the profits achieved by the institution and the investments that contributed to achieving these profits. And profitability is one of the objectives of the financial management in the institution and a measure of judging the adequacy of the institution at the level of the total unit or partial units.
Profitability is measured either through the relationship between profits and sales, or through the relationship between profits and investments that contributed to achieving them, knowing that what is meant by investments is either the value of assets or the value of the owners’ rights of the institution.
In this regard, the following two criteria for measuring profitability will be addressed:
- Return on Aassets or Revenue Power
- Return on Investment
Next is a detailed explanation of each of them:
- Financial Management Encyclopedia, Multi Disciplines Research and Studies Center, 2022.