During a period of economic slowdown, businesses have to strive harder to stay afloat and make profits. How do they assess the risks or profit potential of their ventures with some degree of precision and confidence? That’s where profitability analysis techniques come in. They are used to evaluate profit outcomes and direct businesses to different strategies or models. So what is profitability analysis and how is this process conducted? Let’s discuss all that and more in this guide.
What is Profitability Analysis?
Profitability refers to the profits or gains a business makes in relation to its expenses. Therefore, profitability analysis refers to the process of calculating or analyzing the profits of a business. It helps businesses identify their revenue streams and where they can reduce their expenses to generate maximum gains.
Profitability analysis is an integral component of Enterprise Resource Planning (ERP), which is used to automate and integrate daily business operations. As a part of ERP, profitability analysis helps examine gains generated from different business segments like customers, products, or services. It thus offers quantitative as well as qualitative insights, and helps stakeholders evaluate the elements that generate profit for the business.
Types of Profitability Analysis
Profitability ratios are divided into two broad categories. The first is margin ratios that help analyze how much profit a business is making or can make through its sales. The second is revenue ratios that indicate how the extent of returns a company can provide its shareholders. These two ratios are further categorized into the following types:
Gross Profit Margin
Gross profit margin is the total profit of a business after deducting operational or inventory costs. It represents gross profit of the company in comparison to sales revenue. Gross profit margin is calculated to analyze how much profit a business is making after spending on production of goods or services. If a business has a higher gross profit margin, it means that it can easily cover its operating and other expenses, and still provide a significant amount of net profit. Low gross profit margin indicates that the cost of production is high, and profits earned are low.
Operating Profit Margin or EBIT Margin
This represents how much profit a business has made after deducting variable costs like wages or the cost of raw material. This profit is calculated before deducting taxes or interest. It helps determine whether a company is capable of managing its fixed costs and can run its operations smoothly.
Net Profit Margin
This ratio represents the actual financial position of a company after the taxes and interests have been paid. It indicates a company’s net income or revenue after tax and interest liabilities are paid off. This net profit is utilized to pay dividends to the shareholders. A higher net profit margin indicates that a business is able to keep its expenses low and is making high profits.
Cash Flow Margin
It helps calculate the ability of a business to convert its sales into cash flow. Simply put, cash flow margin represents how much cash or income is a business able to generate from its operating activities. A higher cash flow margin indicates that a company is well-equipped to pay its vendors or suppliers, and purchase capital assets.
Return on Assets
Return on assets means the profit a company generates from its total assets. It compares the profits or net income generated from the assets to the capital invested by the company. Return on assets ratio indicates how well a company is utilizing its economic resources.
Return on Equity
Return on equity indicates how much return a company is able to provide to its equity shareholders. It indicates the efficiency with which a company is managing the capital invested by the shareholders, and how much value it is able to create from it.
Importance of Profitability Analysis
Profitability analysis helps businesses determine future strategies, investments, and the performance of the business by analyzing the current financial position. Here is how businesses leverage profitability analysis to make key decisions:
- Gross profit margin helps businesses determine whether they are making enough profit from their sales. If the gross profit margin is less, the business needs to do cost-cutting
- Profitability analysis also helps potential investors know the financial position of a business and make investment decisions
- Profitability analysis enables businesses to determine the return or profit percentage that they need to pay their shareholders
Profitability Analysis Formula
Profitability analysis is measured in the form of ratios or a percentage. Here are the formulas for different profitability analysis methods:
Gross Profit Margin
Gross Profit Margin = Gross Profit/Sales
Here, you need to first calculate gross profit by subtracting the Cost of Goods Sold (COGS) from the selling price.
Operating Profit Margin
Operating Profit Margin = Earnings Before Interest and Taxes (EBIT)/Sales
You can calculate EBIT by subtracting gross profit from operating expenses. Another way to calculate EBIT is to add taxes and interest to the net income.
Net Profit Margin
Net Profit Margin = Net Income/Sales
You will have to first calculate the net income of the business by subtracting COGS from gross income, and further deduct other expenses like interest and taxes.
Cash Flow Margin
Cash Flow Margin = Cash Flow from Operating Activities/Net Sales
The cash flow from operating activities is calculated by adding net income, non-cash expenses and changes in working capital. You can calculate net sales of the company by reducing sales returns, allowances and discounts from gross sales amount.
Return on Assets
The Return on Assets = Net Income/Total Assets
You can calculate total assets of the company by adding shareholder’s equity amount and the company’s debt.
Return on Equity
The Return on Equity = Net Income/Shareholder’s Equity
Shareholder’s equity can be calculated by reducing the debt amount from the company’s total assets.
Cash Return on Assets
Cash Return on Assets = Cash Flow from Operating Activities/Total Assets
Profitability Analysis Techniques
Break-even point in business is the amount at which your total expenditure is equal to your total revenue. This means that the net profit or net gain is zero. Moreoevr, break-even analysis is one of the best strategies for profitability analysis as it helps you understand the minimum revenue you need to generate in order to sustain your business.
Benchmarking Industry Profitability Ratios
You can analyze business profitability by researching the standard profitability ratio of businesses in your industry. Thus, to set that as a benchmark so that you know whether you will be able to compete in the market.
How to Perform Profitability Analysis
Now that you know what is profitability analysis, let’s understand the steps to be taken to calculate the financial performance of your business:
Step 1: Gather Data
The first step in calculating profitability analysis is gathering the financial data of your business. First, collect all financial statements so that you have accurate details of business revenue and expenditures.
Step 2: Calculate Break-Even Analysis
Then, the next step is to calculate the break-even analysis (as mentioned above), especially when you are planning to invest in a new idea or business.
Break-even cost can be calculated by using this formula:
Break-even cost = fixed costs/contribution margin ratio
Contribution margin ratio = unit price – variable cost per unit/unit price
Step 3: Use Margin or Revenue Ratios
You can use different margin ratio or revenue ratio formulas to calculate the profitability of the business.
An Example of Profitability Analysis
Take a steel manufacturing company that has been facing decreased profits over the last three years. However, the company has made significant profits in the past six months, and it has received an invitation to bid for a project. The management of the company has to figure out whether the company is in a position to take on a new project, and whether the profits generated through this project will be sufficient to sustain the business. In fact, the company will have to calculate the break-even point (explained later in the article) and use profitability ratios to determine whether it can take on a new project.
Maximizing profits is one of the fundamental rules of running a business. Whether you are a finance professional or a business leader, you must know what is profitability analysis and how to calculate it. Emeritus offers several online finance courses to help you learn profitability analysis and other advanced financial concepts. Do check them out and upskill to boost your career.
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