A profitability analysis is a critical tool that allows business owners to review their financial performance and compare it to that of the organization's peers.
Using a profitability analysis, you can deduce your company's efficiencies and determine where improvements are needed. In this article, we'll dive into profitability analysis, what financial metrics they unearth, and how to conduct one in five steps.
What is a profitability analysis?
A profitability analysis uses several financial ratios to evaluate a company’s ability to generate a profit.
Financial planning and analysis () managers assess various aspects of the income statement and balance sheet, including revenue, expenses, assets, and shareholder equity, to benchmark a company’s performance. Managers can compare results from a profitability analysis over different periods or against other businesses in the same market sector for additional data and better decision-making.
Why conduct a profitability analysis?
Business owners may feel content in the knowledge that they're making a profit. However, failing to dive into performance details is a mistake. A profitability analysis allows finance teams to uncover both the efficiencies and inefficiencies of their business operations. Using the knowledge gained from their analysis, managers can adjust their financial management strategies to tap into the potential for future revenue growth and earnings.
Profitability ratios for measuring profit
Gross profit margin and net profit margin ratios are the most commonly used ratios for measuring profitability. Gross profit margin reflects the percentage of your profits left over after factoring in the cost of goods, while net profit margin measures your net profitability after factoring in expenses, interest, and taxes.
You can also include metrics like operational profit margin, margin per user, and cash flow margin in a profitability analysis for a more complete picture of your profitability.
Gross profit margin
The gross profit margin provides finance teams with the percentage of profits after considering the cost of goods sold (COGS). The formula for your gross profit margin is:
((Total revenue - COGS) / (Total revenue)) x 100 = Gross profit margin
In most cases, the gross profit margin should remain flat from one quarter to the next unless the organization alters its methods for creating its products.
Net profit margin
The net profit margin calculates the company's net profitability after considering all expenses, including interest and taxes. Calculate your net profit margin using the following formula:
(Net income / Sales revenue) x 100 = Net profit margin
Finance teams can improve their net profit margin by cutting expenses or growing their revenue.
Operating profit margin
The operating profit margin measures earnings before interest and taxes (EBIT). It's different from the gross profit margin since it considers all operating costs and administrative expenses, not only COGS. To calculate the operating profit margin, use the below formula:
(Operating profit / Total sales) x 100 = Operating profit margin
The operating profit margin reflects total profits before interest and taxes.
Margin per user
Margin per user calculates the company's profits per customer. This metric is useful for organizations that follow a subscriber-based business model but may also be appropriate for other sales models. To determine the margin per user, apply the following formula:
((Total revenue - Operating expenses) / Users for period) = Margin per user
Finance teams can further analyze the margin per user by dividing the months included in the financial statements.
Cash flow margin
Cash flow margin calculates how much income, or cash, a business is generating from its operating activities. In other words, it’s a measure of how well a company translates sales into cash. The formula for calculating cash flow margin is:
(Net cash from operating activities / Net sales) x 100 = Cash Flow Margin
A higher cash flow margin suggests a more efficient business, since a greater proportion of its sales are converted into cash.
Revenue ratios
Profit is the amount of cash remaining after accounting for all of your business expenses. Revenue, on the other hand, is the total amount of income generated without accounting for expenses.
In addition to profitability ratios, your business may want to include revenue ratios in its financial reports. Here are the two types of revenue ratios and their calculations:
Return on assets
Return on assets (ROA) refers to the profit generated from a company’s total assets. It compares profit or net income generated from the assets against any cash invested into the company. The return on assets ratio measures how efficiently a company is using its funding.
The formula for calculating return on assets is:
(Net income / Total assets) x 100 = ROA
In general, the higher the ROA, the better.
Return on equity
Return on equity (ROE) refers to the amount of returns a company can provide its shareholders. It’s an indicator of how efficiently a company manages its capital invested by shareholders and how much value it’s able to create using it.
The formula for calculating return on equity is:
(Net Income / Shareholders' Equity) = ROE
Investors tend to prefer companies with a higher ROE, as it signifies better financial health and higher returns on their investments.
How to complete a profitability analysis in five steps
Here’s how to complete a profitability analysis step-by-step, including the most commonly used profitability ratios:
1. Gather financial statements
To calculate the appropriate metrics for your profitability analysis, you'll need the and balance sheet for your own company and those of a competitor for the same period. Below are sample financial details of two hypothetical companies for the year:
2. Calculate the profitability metrics for each company
Using the financial details given in step one, we'll conduct a profitability analysis for both companies.
Gross profit margin
Company A:
(($1M total revenue - $800K COGS) / ($1M total revenue)) x 100 = 20% gross profit margin
Company B:
(($1.25M total revenue - $950K COGS) / ($1.25M total revenue)) x 100 = 24% gross profit margin
Operating profit margin
Company A:
($100K operating profit / $1M total sales) x 100 = 10% operating profit margin
Company B:
($200K operating profit / $1.25 M total sales) x 100 = 16% operating profit margin
Net profit margin
Company A:
($50K net income / $1M sales revenue) x 100 = 5% net profit margin
Company B:
($100K net income / $1.25M sales revenue) x 100 = 8% net profit margin
Margin per user
Company A:
(($1M total revenue - $900K total expenses) / 10K users for period) = $10 margin per user
Company B:
(($1.25M total revenue - $1.05M total expenses) / 12K users for period) = $16.67 margin per user
Return on assets
Company A:
($50K net income / $500K total assets) x 100 = 10% return on assets
Company B:
($100K net income / $750K total assets) x 100 = 13.3% return on assets
3. Compare the results
Next, prepare a spreadsheet detailing the results of the profitability analysis:
In this example, the results show that Company B has better profitability across all measurements.
4. Determine the drivers for differences
You'll need to determine the reasons for the differences in profitability between both companies. Using each measurement, consider the underlying factors to determine why Company B is performing better than Company A.
As an example, the gross profit margin for Company B surpasses Company A's. Company B's revenue is higher, but its COGS is less as a percentage of its revenue than it is for Company A. Company B seems to have found a cheaper way to produce products than Company A.
The financial statements for both companies show the same operating expenses, even though Company B generated more revenue and has a larger user base. In this case, Company A should take a detailed look into its operating expenses to see if it’s spending too much on overhead and administrative costs.
5. Take action
Completing a profitability analysis is fruitless if management doesn't make changes. The results from the profitability analysis provide your with an opportunity to adjust your operating model to improve future earnings.
Other types of financial modeling
Profitability analyses aren’t perfect. They only consider past information, which quickly becomes outdated as your company continues to grow.
A profitability analysis also doesn't account for risk. Sometimes, companies take on a significant risk that isn't likely to immediately pay off. In this instance, they may have a higher potential for profits in future years.
You can get a more complete picture of your company’s financials by including other financial models, like a break-even analysis and valuation models, in your budgeting process. Financial forecasting can also help you determine your future profitability, instead of merely looking at your current bottom line.
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