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Thursday, October 27, 2011

Concept of Profitability of a Firm

When a business is started, an investment is made into the firm in areas such as machinery, land, inventory and other assets. By investing in these assets, the business wants to produce a value, a product or a service to sell it to the end users for a profit.

When we look at the financial side of the business and its activities, we can understand that the assets of the firm are put on the right hand side and the liabilities are put on the left hand side. The assets and liabilities must match in figures. When we look closely at the assets and liabilities, we can see that assets include machinery, land and buildings, inventory, patents, trademarks, investments, debtors, etc.

On the other hand, if we look at the liabilities side of the balance sheet, we can find share capital, long term liabilities such as bank loans, term loans, debentures and short term liabilities or current liabilities such as creditors, bills payable, expenses to be paid, etc. This is the capital structure of a firm.

The firm, in order to make profits, the firm must create more cash flow than it uses. In other words, the cash coming in from the various activities must be more than the money invested by the firm. This increase in the cash flow over a period of time is called profit, which is usually calculated over one year, half year or a quarter of a year.

In order to generate more profits, the firm can take up what is called cost reduction. In cost reduction, by using new machinery, or new ways of production, the firm tries to reduce the cost of production to the extent possible. Cost reduction is considered to be one of the best techniques for profit maximization.

Another way that firms can increase their profits is through producing in bulk quantities. When produced in bulk quantities, the firm will experience a decreased cost on individual product produced. So, the decrease in cost of production without the proportional decrease in price will increase the profit of the firm.

In order that cost reduction and increased production takes place, a firm must utilize highly economic ways of production such as utilization of efficient techniques in production and procurement of materials in bulk from suppliers, etc. All these techniques are known to decrease the cost of production and increase the profitability of the firm.

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