The primary purpose for establishing and maintaining any business is to generate profit. From the moment of conception onward, all activities of the business are focused on creating, growing, and maximizing profit. Key leaders in the organization use a variety of tools to help them identify ways to grow and maximize the bottom line. Profitability Analysis is one such tool.
What Is Profitability Analysis?
Profitability analysis is an analytical process that seeks to reveal information about the various revenue streams of the organization. It helps leaders to identify ways to optimize profitability and is used to assist in Enterprise Resource Planning (ERP).
Advancements in ERP solutions have enabled analysts to gather more transparent and insightful information. This information is used in various ways to analyze profitability as it relates to customers, vendors, locations, and product lines.
One common misconception of profitability analysis is that it is purely quantitative. Analyzing profitability requires a combination of both quantitative and qualitative analytics. This helps to provide leaders with a more robust view of the various profit drivers in the business and how to maximize those drivers.
What Is Profitability Analysis Used For?
It is important for leaders to have a good understanding of the quality of a business’s earnings. To that end, profitability analysis serves several purposes and is used for a variety of things.
Keeps Track Of Performance
Analyzing profitability over extended periods of time helps create and maintain a track record of performance. A track record is helpful in the continued analysis of future profitability ratios and is used to forecast and plan as well.
Identify Optimal Product Mixes
One of the primary uses of profitability analysis is to reveal which combination of products will result in the most profit.
Maximize The Use Of Assets
Profitability is often analyzed in conjunction with the business’s assets to provide indicators on how effective the organization is at utilizing its assets to create gross sales and generate profits.
Understand Return On Equity (ROE)
ROE is a financial metric that measures how effective the business is at generating a return for its equity investments.
Examine Vendor And Customer Relationships
Profit Analysis is often performed as it relates to customers and vendors which helps to identify which are the most and least profitable.
Methods Of Profitability Analysis
There are various methods used to analyze profit. Each method utilizes a different approach to provide some insight into profitability. While each business might differ slightly in how it personally conducts its profit analysis, these methods are commonly used in the regular course of business.
Ratio Analysis
Ratio analysis is a method that combines the use of margin ratios and returns ratios. The ratios are analyzed both individually and comparatively with the broader industry standards. Margin ratios are concerned with a profit margin at various levels while return ratios focus on how effective the business is at using its resources to generate income. Generally speaking, the higher the ratio the better.
Gross Profit Margin is a margin ratio that demonstrates the cost of goods (COGS) sold as a percentage of sales. Both COGS and total sales can be located on the income statement. The ratio examines how effectively a business is managing its cost of inventory and the manufacturing of its products. It is also used as a way to measure the ability of the business to pass its COGS on to its customers.
Gross Profit Margin (%) = Gross Profit ($) / Sales ($)
Operating Profit Margin is another margin ratio that is used as a way to understand how efficient a business is at managing its operations. Operating margin is a company’s earnings before interest and taxes (EBIT). It builds on gross profit margin as it layers in the impact of ordinary operating expenses, or overhead.
Operating Profit Margin (%) = EBIT ($) / Sales ($)
Net Profit Margin is the most commonly used margin ratio and is the percentage of net income to sales. This ratio considers net income after accounting for all expenses of the business.
Net Profit Margin (%) = Net Income (%) / Sales (%)
Cash Flow Margin is the final margin ratio. It illustrates the relationship between cash generated during the normal course of operations and sales. The ratio is used to understand how effective the business is at converting sales to cash. It relies on information from both the income statement and statement of cash flows.
Cash Flow Margin (%) = Cash Flow From Operating Cash Flows ($) / Sales ($)
Return on Assets (ROA) is a return ratio that demonstrates the business’s ability to generate profits using its assets. It measures profitability as it relates to the investments that have been made into the organization’s total assets. It compares net income from the income statement to total assets on the balance sheet.
ROA (%) = Net Income ($) / Total Assets ($)
Return on Equity (ROE) is a return ratio that reveals the return that the business has generated for its investors. It compares shareholder’s equity on the balance sheet to net income.
ROE (%) = Net Income ($) / Total Shareholders’ Equity ($)
Cash Return on Assets is a return ratio that is used to eliminate the potential noise created by accounting policies by comparing cash generated from operations to total assets. It is used to measure how effective the business is at generating cash with its assets.
Cash Return on Assets (%) = Cash Flow From Operations ($) / Total Assets ($)
Break-Even Analysis
Break-even analysis is used to identify how much revenue is needed to cover all fixed and variable expenses. It is the point at which net income is zero, and expenses equal revenue exactly. It is one of the most common business metrics used as it is a safety calculation that indicates how much in sales must be achieved to remain operating.
One Critical Assumption When Conducting Profitability Analysis
One broad observation across most organizations is that 80 percent of a business’s revenue is generated by just 20 percent of its customers. It is sometimes referred to as the 80/20 rule. Oftentimes this is misconstrued to mean that the 20 percent of customers that drive the majority of the revenue are the most valuable.
The basic premise of conducting profitability analysis is to separate revenue from profit. While some customers may generate large amounts of revenue, they may not be as profitable as other customers. In some cases, they may even be unprofitable. It is important to avoid making broad assumptions on the quality of a customer till sufficient profit analysis can be completed.
How To Analyze Profitability
In order to analyze profit sufficiently, it is important to have a full set of financial statements or financial reports, a balance sheet, an income statement, and a statement of cash flows. Even more important is to have access to historical information and industry standards. At a minimum, profitability should be viewed over time and trends should be identified in the resulting analysis.
Step 1: Calculate Break-Even
Break-even analysis should be performed first. This helps to establish how many units need to be sold to break even. Taking it further, it is important to perform a break-even analysis on customers to identify how many units must be sold to each customer to break even.
Finally, it is important to subject the break-even analysis to “what-if” planning or scenario-based plans. This helps to understand the points at which your break-even becomes unsustainable or may illuminate ways to reduce it.
Step 2: Ratio Analysis
Using the ratios identified above, begin generating current profit ratios and return ratios for the period. If you haven’t already, compute the same ratios for prior periods. Graph the results to see how they are trending over time and by customer. Look out for important trends such as growing customer orders, but decreasing profit.
Step 3: Compare To Industry Standards
Finally, take all of the information gathered from your break-even analysis and your ratio analysis and compare it to the industry standards. Doing this well helps provide context for how well the organization is doing. For example, ROE might seem low but when compared to other similar firms operating in the same industry it could be the opposite. Without the context of how the organization is performing within its industry, it is impossible to correctly benchmark any of the metrics created during the analysis.
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