How to conduct (and interpret) a profitability analysis for your business
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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 metrics to evaluate a company’s ability to generate a profit.
Financial planning and analysis (FP&A) managers assess various aspects of the income statement and balance sheet, including revenue, expenses, assets, and shareholder equity, to benchmark the performance. Managers can compare results from a profitability analysis over different periods or against other businesses in the same market sector to make additional observations.
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 analysis ratios and metrics to know
A complete profitability analysis interprets various ratios and metrics. Here are a few of the most common ones.
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.
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 overhead 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.
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.
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.
Return on assets (ROA) is a simple profitability metric that evaluates an organization's income in relation to its total assets. ROA helps determine how efficiently a company uses its available assets to generate a profit. The below formula calculates your ROA:
(Net income / Total assets) x 100 = ROA
In general, the higher the ROA, the better.
How to complete a profitability analysis in five steps
We’ll use the formulas provided in the preceding section for this profitability analysis example.
Step #1. Gather financial statements
To calculate the appropriate metrics for your profitability analysis, you'll need the profit-and-loss (P&L) statement 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:
Step #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
(($1M total revenue - $800K COGS) / ($1M total revenue)) x 100 = 20% gross profit margin
(($1.25M total revenue - $950K COGS) / ($1.25M total revenue)) x 100 = 24% gross profit margin
Operating profit margin
($100K operating profit / $1M total sales) x 100 = 10% operating profit margin
($200K operating profit / $1.25 M total sales) x 100 = 16% operating profit margin
Net profit margin
($50K net income / $1M sales revenue) x 100 = 5% net profit margin
($100K net income / $1.25M sales revenue) x 100 = 8% net profit margin
Margin per user
(($1M total revenue - $900K total expenses) / 10K users for period) = $10 margin per user
(($1.25M total revenue - $1.05M total expenses) / 12K users for period) = $16.67 margin per user
Return on assets
($50K net income / $500K total assets) x 100 = 10% return on assets
($100K net income / $750K total assets) x 100 = 13.3% return on assets
Step #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.
Step #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.
Step #5. Take action
Completing a profitability analysis is fruitless if management doesn't make changes. The results from the profitability analysis provide the FP&A team with an opportunity to adjust the organization's operating model to improve future earnings.
What a profitability analysis doesn't tell you
Profitability analyses aren’t perfect. They consider only past information, which quickly becomes outdated as the company continues to grow.
Some companies use different financial reporting practices than others. These differences may lead to challenges in comparing profitability metrics between different organizations or jurisdictions.
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, the organization may have a higher potential for profits in future years.
The two main types of profitability analysis include ratio analysis and customer profitability analysis. Profitability ratios consider the company’s performance, while a customer profitability analysis considers profits based on the number of clients.
The primary reason for conducting a profitability analysis is to evaluate the business performance across periods or between companies in the same market sector. Insights from a profitability analysis allow managers to improve their decision-making to enhance future earnings.
Performing a profitability analysis allows for better P&L management using simple financial metrics that are trackable over time. All businesses should regularly use a profitability analysis alongside other metrics to understand their efficiencies and identify problem areas. However, the profitability analysis does have drawbacks: It's not a forecasting tool, and the results from the profitability analysis quickly become outdated.