Economic profitability: What it is and how to calculate it

Economic profitability is an essential concept that any investor or entrepreneur must understand to evaluate the success of an investment or business project. Beyond the profits obtained, economic profitability measures the efficiency of the resources used to generate those profits.

In this article, we will define what economic profitability is, why it is so important, how it is calculated, and what factors influence its outcome.

What is economic profitability?

Economic profitability is defined as the ability of a company or investment to generate profits in relation to the assets used. It is a fundamental metric for evaluating the efficiency of business management, as it measures performance in absolute terms without considering the source of the funds (whether they are owned or borrowed).

This indicator helps investors and business owners understand if a company's resources are being used optimally. The higher the economic profitability, the more efficient the company is in generating income based on its total assets.

Types of economic profitability

There are several ways to analyze economic profitability, and it is important to understand the differences between them to apply the correct metric in each case:

• Gross Profitability: This reflects the profit generated before deducting taxes and other non-operating expenses. This type of profitability offers a preliminary view of the company’s efficiency but does not account for tax commitments.
• Net Profitability: This measures the profits obtained after taxes and additional expenses. It is a more realistic indicator of profitability, as it reflects the final profits available for shareholders or reinvestment.

It is important to distinguish between economic profitability and financial profitability. How do they differ, and what are their specific characteristics?

• Economic Profitability: Focuses on the return generated by all of a company’s assets.
• Financial Profitability: Analyzes the return on equity or shareholders’ capital.

Both economic profitability and financial profitability provide important data for obtaining a comprehensive view of a company’s financial health.

Formula for calculating economic profitability

Calculating economic profitability is a straightforward process and is done using the following formula:

• Economic Profitability (%) = (Net Profit / Total Assets) x 100

This formula yields a percentage indicating the proportion of profits obtained relative to the assets used. Below is a practical example:

Imagine a company has a net profit of 75,000 euros and total assets of 600,000 euros. Applying the formula in this case would give the following result:

• (75,000 / 600,000) x 100 = 12.5%

The result of this calculation shows that the company generates a profit of 12.5% based on the total value of its assets. This indicator can be used as a reference to compare the profitability of different projects or businesses, helping investors choose the best opportunities.

Factors influencing Economic Profitability

Economic profitability is not solely focused on net profit or assets; it also involves other key factors that can influence its outcome. Below are some of these factors and how they affect economic profitability:

• Operating Costs: As operating costs increase, economic profitability may be negatively affected. Controlling expenses on raw materials, personnel, or logistics is crucial to maintaining a positive profitability rate.
• Sales Volume and Profit Margins: The higher the sales volume and profit margins, the greater the economic profitability. This is especially important in industries with high competition, where margins are typically smaller.
• Product Life Cycle: Profitability may vary depending on the phase of the product or service being offered. During the introduction and growth phases, large investments are often made that temporarily reduce profitability. However, during the maturity phase, profitability tends to stabilize and become more predictable.

Profitability and risk: How do they influence investment?

When evaluating the profitability of an investment, it is essential to consider the associated risk. In general, investments with higher potential profitability also involve higher risk. However, the goal of any investment should be to manage and diversify risk effectively.

Crowdlending platforms like Inversa allow investors to participate in loans to small and medium-sized companies. This can provide attractive returns with controlled risk. These investments allow investors to diversify their portfolios, reducing the impact of potential defaults.

How to balance risk and profitability? To balance risk and profitability, it is crucial to evaluate each investment project individually and ensure it aligns with the investor’s risk profile. In the case of Inversa, diversification and selecting solid projects are two tools that can help mitigate risks and optimize the profitability of the investment.

Tools for measuring economic profitability

Several indicators and tools are available for measuring the profitability of an investment or business more accurately:

• ROI (Return on Investment): Measures the return obtained relative to the initial investment. It is used to evaluate the effectiveness of an investment.
• ROE (Return on Equity): This ratio measures financial profitability and is calculated by dividing net profit by shareholders’ equity.
• ROA (Return on Assets): Assesses the efficiency of total assets in generating profits, similar to economic profitability but focused on the return obtained from the assets themselves.

Nowadays, there are various financial analysis platforms that facilitate these calculations, helping investors make informed decisions. Having specialized software or using financial advisory services, like those offered by Inversa, can make the difference between a successful investment and a poor one.

Importance of tax advisory

Optimizing economic profitability is not only influenced by investment decisions but also by proper tax management. A tax advisor can help reduce the tax burden by identifying applicable tax deductions and taking advantage of tax benefits associated with certain investment products.

As you can see, tax advisory is key to maximizing investment profits and avoiding errors that could affect a project’s profitability.

At Inversa, for example, working with our tax advisors can help you understand how crowdlending returns are taxed and what tax strategies can be applied to reduce the impact of income tax (IRPF).

Review your tax situation annually

An important aspect of optimizing profitability is conducting an annual review of your tax situation. Personal and professional circumstances change, which can affect both your investments and your tax burden. With an annual review, you can adjust your investment strategy accordingly, optimizing tax benefits and improving long-term profitability.

Another point to keep in mind is that tax regulations are subject to change, so staying up to date is essential for taking advantage of new savings opportunities and avoiding penalties.

The importance of economic profitability in investment decision-making

Economic profitability is a key indicator for evaluating the efficiency and success of an investment or business. Understanding how to calculate it, knowing all the factors that influence it, and using the right tools for its measurement allows for more informed financial decisions.

Additionally, having a good tax advisor and periodically reviewing your financial situation will help you optimize your investments and maximize long-term profitability. At Inversa, we are proud to be an alternative financing platform that has managed to maintain investment security without sacrificing profitability, making it a perfect option for those seeking a place to invest their money with low risk while enjoying great benefits.