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 and financial profitability, the first of the concepts translates as the ratio of earnings before interest and taxes (gross profit) to total assets. It is therefore a question of establishing the capacity of all the company's assets and resources to generate positive results, regardless of how they have been financed or how much they have meant for the company.
On the other hand, financial profitability refers, according to the same author, to the ratio between net profit and equity capital, i.e. it calculates the capacity to generate positive results from own funds.
Based on these definitions, it can be seen that economic and financial profitability are based on different elements when computing the company's profit. Thus, while the economic one takes into account the total assets of the company, the financial one only uses equity as a basis..
On the other hand, profits are not based on the same level either. More specifically, economic profitability uses the amount of earnings before interest and taxes, whereas financial profitability is based on the profit figure after deducting 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 these items are calculated.
ROI (Return on Investment) is determined by dividing earnings before interest and taxes (BAII) by total assets.
In addition to the ROI, it is also important to know the ROE (Return on Equity), the most important metric for profit-oriented companies, This ratio is calculated by dividing the net profit obtained by dividing the net profit by the shareholders' investment. This ratio is calculated by dividing the net profit (after tax) in equity.
How would you calculate the economic and financial profitability of a company? We collect the example of a company addressed by Espinosa:
Thus, the 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%.
However, in this case, the difference between the two magnitudes is minimal, it may be the case that economic profitability is positive, but financial profitability leads to losses for investors., The company has to pay a significant amount of interest and taxes that are not amortised over the revenues.
Hence the importance of differentiating between the two concepts in order to obtain an accurate picture of the situation. of the organisation and making sure that finances are going well.
