The concepts of economic and financial profitability highlight two different realities. Although they may be used in everyday language as synonyms, in the business world they present two distinct realities. There are slight differences that make a correct understanding and application of both terms necessary if we want to realise an optimal organisational strategy.
According to the Royal Academy of the Spanish Language, profitability refers to the action of producing a profit. However, the way in which this benefit is calculated and the parameters taken into account for its computation will vary the final result and this is where the importance of determining economic and financial profitability comes into play.
In the same way that an employee's gross salary is not the same as his or her net salary, even though both are benefits, for companies also differs the final result of economic and financial profitability.. In what sense?
As David Espinosa explains in his work Economic profitability and financial profitability, the first of the concepts translates as the relationship between profit before interest and tax (gross profit) and total assets. It is therefore about establishing the capacity to generate positive results from all the company's assets and resources, regardless of how they have been financed or how much they have cost the company.
In contrast, financial profitability, according to this same author, refers to the Net profit to equity ratio, i.e. it calculates the capacity to generate positive results from own funds.
Drawing from these definitions, it can be observed that economic and financial profitability are based on different elements when calculating a company's profit. Thus, While the economic approach takes into account the company's total assets, the financial approach only uses equity as its basis..
On the other hand, profits are not based on the same level either. More specifically, in economic profitability, the amount of earnings before interest and taxes is used; in financial profitability, on the other hand, one starts with the figure of profit after deductions the corresponding interest, taxes and financial expenses.
However, the best way to understand the difference between economic and financial profitability is through a practical example. To do this, it is first necessary to know How are these concepts calculated?.
The ROI (Return on Investment) is determined by dividing the earnings before interest and tax (EBIT) by total assets.
Alongside the ROI, it is also crucial to know the ROE (from English Return on Equity), the most important parameter for profit-making companies, as it highlights the net profit obtained compared to shareholder investment. This ratio is calculated by dividing the net profit (after tax) to equity.
How would the economic and financial profitability of a company be calculated? We collect the example from a company approached by Espinosa:
Thus, Economic and financial profitability would be:
ROI= (Gross Profit / Total Assets)*100= (17,000/100,000)*100= 17%.
ROE= (Net Profit / Own Assets)*100= (11,400/70,000)*100)= 16,29%.
Although in this case, the difference between both magnitudes is minimal, It can happen that economic profitability is positive, but financial profitability leads to losses for investors., because a large part of the capital is borrowed and the company has to pay a significant amount of interest and taxes which are not offset by income.
From there the importance of differentiating both concepts to obtain a faithful picture of the situation of the organisation and making sure that finances are going well.
