The goal of any business is to make money and understanding your company’s profitability is critical. While some businesses are able to operate at a loss for several years, every business needs to become profitable.
However, accounting policies are used to create tax efficiencies, and analyzing whether a business is profitable or not requires an understanding of how a company’s profitability is derived.
In this FAQ we will cover what profitability is for a company, why it is important, and how to calculate and analyze a company’s profitability.
What Is A Company’s Profitability
In simple terms, a company’s profitability is the extent to which its total income exceeds its total expenses for any given period. Profitability is an accounting concept that is sometimes referred to as net profit or net income.
In financial reporting accounting policies can impact how income statements, or statements of operations, present income and expenses. In some cases, businesses use accounting policies to take advantage of tax law and minimize their tax liability.
In cases like this, net income can be somewhat muddled, and therefore many financial analysts rely on the quality of earnings rather than net income or profitability.
In these cases, earnings before interest, taxes, depreciation, and amortization (EBITDA) are used to gauge the quality of a company’s earning potential.
Why Understanding A Company’s Profitability Is Important
At the end of the day, a business’s primary objective is to make money. The amount of money made after considering every avenue of earnings and expenses is the profitability of the business. If a business is not profitable, it will not last.
Even organizations that are extremely profitable and have bright futures are subject to failure if they cannot maintain profitable operations. Profitability is used when analyzing whether or not a business is a going concern and can continue to operate in its current capacity.
The term “going concern” is a concept in accounting that is used to label businesses that have the resources required to operate indefinitely. It is a way to express whether a business has the ability to generate enough income to satisfy all expenses and service its debt obligations.
When a business is no longer a going concern, it has filed for bankruptcy or was forced to liquidate assets.
Understanding your company’s profitability is critical in assessing whether or not the product or service that is being sold is worth the effort. When starting a business, there should be some understanding of whether or not it will make money.
As a business grows and matures, additional analysis should be performed on a company’s profitability to determine the quality of its net income.
How To Calculate And Analyze A Company’s Profitability
Calculating profitability is not inherently difficult or time-consuming. In some cases, non-cash expenses are removed from the equation, but some iterations of calculating profitability include non-cash expenses for accrued expenses, amortization, or depreciation.
For example, accrued expenses for maintenance, service providers, or other one-time annual expense payments should be considered when calculating net profit in the periods when the expenses are not being paid. Conceptually, this makes sense as you would not have a complete view of profitability without considering these expenses.
Accrued income and expenses are especially important to pay attention to when assessing profitability and it is important to note that profitability is not reflective of cash flow.
US Generally Accepted Accounting Principles (US GAAP), require that both revenue and expenses be recorded in the period they are incurred when a business adopts accrual-based accounting.
This is separate from cash accounting which requires revenue and expenses at the time cash is received or distributed. In most cases, a business should be operating under an accrual-based accounting policy.
While both methods get you to the same place, in the end, accrual-based accounting is considered to be a more inclusive and transparent method of record keeping.
The formula for calculating profitability, or net income, is the sum of all revenue less the sum of all expenses. It can be expressed mathematically as:
P= Ri – Ei
- P = Profitability
- Ri = All sources of revenue
- Ei = All sources of expenses
For example, let’s assume that a business sells both tires and hubcaps. Revenue from its tire products amounted to $1.0 million for the year while hubcaps generated $250,000 for the same period.
The business incurred fixed expenses of $300,000 and variable expenses of $200,000. In this case, the formula would be expressed as follows:
P = ($1,000,000 + $250,000) – ($300,000 + $200,000) = $750,000
The net profit in this example is $750,000.
Considerations For Analyzing Profitability
When analyzing profitability it is important to consider the product/service demand, supply, and any other economic factors that might impact the bottom line.
Profitability as a metric can be used in the analysis of merging two businesses where operational efficiencies and increased product offerings might create more, or higher quality, profit.
In addition, profitability is used when determining whether to expand operations. For example, if operations expand it might result in lower costs, but the increase in supply might drive prices down resulting in less profit than if the business had not expanded. Conversely, it might be that expanding operations results in more profit.
Using DataRails to Calculate Your Company’s Profitability
Every finance department knows how important it is to understand your company’s profitability. Regardless of the type of analytics you are performing, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
DataRails’ FP&A software is an enhanced data management tool that can help your team create and monitor financial forecasts faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes financial planning and analysis from time-consuming to rewarding.