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# Profitability analysis

## What is profitability analysis used for?

Profitability analysis is an analytical tool for determining a company's ability to generate profit. A profitability analysis examines a company from multiple perspectives, including how much profit it earns per sale or how many sales it needs to break even. Thankfully, most of this information is easily accessible on a company's financial statements.

## What is profitability analysis?

The basic function of every business is to generate profits. So as a business owner or manager, you must assess whether your enterprise is profitable. The process of doing so is 'profitability analysis.'

A profitability analysis involves tracking your company's performance, determining the break-even sales volume and revenue, and creating 'what if scenarios. This information helps you better understand how your company works and under what conditions it generates the most profit.

## Why is profitability analysis critical?

Profitability analysis is essential because it helps you evaluate and track your company's performance. Specifically, profitability analysis lets you do the following:

1. Analyze sales data to identify the most and least profitable products and services.
2. Evaluate performance over time by comparing current data with historical data.
3. Compare your company's performance with competitors in the same industry.

You can combine this information to produce a holistic understanding of your company's profitability.

## What are the two types of profitability analysis?

There are two types of performing profitability analysis: ratio analysis and break-even analysis. Each approach uses a different method and each approach has their own profitability ratios. Ideally, you want to use both to conduct a thorough profitability analysis.

### Ratio analysis

Ratio analysis involves comparing two metrics, like profit vs. cost. Ratio analysis expresses a company's performance in how much return they gain from what they invest.

Companies use ratio analysis to understand the percentage of profit they make on sales, how much return they receive on investments, and how well they utilize their assets. There are two types of ratio analysis: margin ratios and return ratios.

Margin ratios indicate how well businesses produce profits from a product or service. Return ratios inform how efficiently a company manages its internal resources and produces returns for its shareholders.

#### The four types of margin ratios

###### 1. Gross profit margin

The gross profit margin ratio expresses the percentage of revenue that businesses retain as profit. Naturally, companies want a large gross profit margin since it means they manage production costs better.

Businesses calculate gross profit margin by subtracting costs from revenue to obtain profit. Next, they divide gross profit by revenue.

##### Gross Profit Margin=Gross Profit/Sales

For example, if a business's total revenue is \$100 and its total costs are \$40, its gross profit is \$60. Dividing \$60 by \$100 gives us 0.6 or 60% of their gross profit margin. This gross profit margin means they keep 60% of their revenue as profit.

Gross profit margin is important because it looks at your company's inflows and outflows. You need a high gross profit margin to cover your cost of goods sold. You also want a stable gross profit margin.

A fluctuating gross profit margin highlights instability. Ideally, you only want it to change because of a change in pricing or other company policies.

###### 2. Operating profit/Earnings before interest and taxes (EBIT) margin

The operating profit margin of businesses reveals how much profit they retain after paying operational expenses but before paying interest and taxes. You'll calculate your operating profit margin by dividing your earnings before interest and taxes by revenue.

##### Operating profit margin=Earnings Before Interest and Taxes (EBIT)/ Sales

Let's say a company's EBIT is \$40, and its revenue is \$100. This information means their operating profit margin is \$40/\$100=0.4 or 40%

The operating profit margin indicates the quality of management and operating efficiency of a business. You can also compare your operating profit margin with competitors since similar businesses have similar operating profit margins. Some financial analysts consider operating profit margin to be a more objective measurement of a company's performance since it analyzes pre-tax incomes, unlike net profit margin.

###### 3. Net profit margin

Net profit margin reveals the percentage of revenue retained as profit after paying both operating expenses, taxes, and interest. It's the most commonly used profitability ratio since it reveals how much money is left after costs.

Businesses calculate net profit margin by dividing net income by revenue.

##### Net Profit Margin=Net Income/Revenue

For example, a business may have \$50 in net income and \$100 in revenue. Their net profit margin would be \$50/\$100=0.5 or 50%.

A higher net profit margin means a business retains a larger percentage of its revenue as profit.

###### 4. Cash flow margin

Cash flow margin expresses what percentage of revenue is liquid. All businesses need cash to pay operating expenses, pay dividends to shareholders, and invest in new assets.

Businesses calculate cash flow margin by dividing the amount of cash they earn by their net revenue.

##### Cash flow margin=Cash flow / net revenue

For example, a company's cash flow could be \$100 and net revenue \$750. This gives a cash flow margin of \$100/\$750=0.75 or 75%, which means the company is highly liquid.

A high cash flow margin means that businesses have more liquidity. Higher liquidity is beneficial since it means a business can better handle sales disruptions and pay costs.

#### The three types of return ratios

###### 1. Return on investment(ROI)

Return on investment(ROI) measures the percentage of profit earned from a financial investment. ROI can be broadly used for different types of investments, including in stocks, business assets, and other securities.

Businesses and investors calculate ROI by dividing the profit gained from an investment by its investment expense.

##### Return on investment=profit from investment/Investment expense

For example, a business could invest \$1,000 in a new manufacturing unit. The profit they earn from the unit in a year is \$500. Hence the ROI is \$500/\$1,000= 0.5 or 50%.

A higher ROI means an investment will yield higher profits relative to the amount invested. But it does not represent the absolute gain from an investment. Suppose in the above example, the business instead invested \$2,000 in marketing and gained \$800 in profit, giving an ROI of 40%.

Although their ROI from marketing is less than that of a new manufacturing unit, the company earns more money from marketing because it invested a larger amount in marketing.

###### 2. Return on equity (ROE)

Return on equity(ROE) informs how much profit a business generates for its shareholders. Investors prioritize this ratio since it tells them what return to expect from an investment.

Investors calculate ROE by dividing net income by shareholder equity.

##### Return on equity= Net Income/Shareholder's equity

For example, a company could have \$100 in net income and shareholder equity of \$200. Their ROE would be \$100/\$200=0.5 or 50%.

Investors want investments to have as high an ROE as possible.

Check out the difference between ROI and ROE

###### 3. Cash Return on Assets (ROA)

Return on assets (ROA) measures the percentage of return a business produces from existing assets. A company's ROA indicates the efficiency of its internal resource allocation.

Businesses calculate ROA by dividing their cash flow by the value of the assets.

##### Cash Return on Assets=Cash Flow From Operating Activities/ Total Assets

For example, a business could have \$100 in cash flow from operating activities and \$300 in total assets. Their ROA would be \$100/\$300=0.3 or 30%.

What constitutes a good ROA depends on the industry. But generally, an ROA of 5% is considered good, and one above 20% is considered excellent.

### Break-even analysis

A break-even analysis identifies a company's 'break-even point,' the level at which its revenue equals its costs. Before reaching its break-even point, a company is in the red, meaning its costs exceed its revenue. After passing the break-even point, they're in the black. Their revenue exceeds their costs.

All points after the break-even point generate profit. So knowing a company's break-even point reveals at what level of sales it can become profitable. Break-even point analysis simplifies the relationship between costs, revenue, and sales volume.

If you're currently profitable, a break-even analysis reveals the minimum sales volume needed to stay viable. If you're not profitable, a break-even analysis tells you how much you need to sell and at what price to become profitable.

#### Contribution margin

A product's contribution margin reveals the difference between its price and total variable cost. This ratio is specific to a product or service rather than a whole company.

Businesses calculate contribution margin by subtracting a product's price and variable cost per unit.

##### Contribution Margin=Price of product - Total variable cost per unit

For example, a product's revenue could be \$100, its total fixed costs could be \$20, and its total variable costs are \$60. its contribution margin would be \$100 - \$60 =\$40. This \$40 is the revenue used to cover the remaining fixed costs, which are excluded from the contribution margin calculation.

#### How to perform a break-even analysis

You can perform a break-even analysis by calculating the break-even volume, revenue, or both.

###### 1. Break-even sales volume

You'll calculate break-even sales volume by dividing total fixed costs by a product's contribution margin. Suppose a product's fixed costs are \$3,000, its contribution margin is \$60, and the break-even volume is 500 since 500 units * \$60 = \$3,000.

##### Break-even sales volume=total fixed costs/contribution margin.

Selling 500 units of this product generates exactly enough revenue for a company to pay its fixed cost of \$3,000. The company breaks even at the 500 sales point since it doesn't generate any profit.

###### 2. Break-even revenue

Calculating break-even revenue consists of dividing total fixed costs by the contribution margin. Remember, the contribution margin ratio is the contribution margin per unit divided by price.

##### Break-even revenue= Total fixed costs/ contribution margin

Suppose a company's contribution margin ratio is \$40/\$100= 0.4 or 40%. And their total fixed costs are \$3,000. Their contribution margin ratio would be \$3,000/ 0.4 = \$7,500.

You can confirm this figure by calculating total revenue by multiplying the break-even volume (500) with the price (\$100), which gives \$50,000. These examples show you can calculate break-even volume if you have break-even income and vice versa.

## How do I perform a profitability analysis?

The best way to analyze a company's profitability is with as much financial data as possible. You want access to all the company's financial statements, including their balance sheet, income sheet, and statement of cash flows. You'll use this information to holistically analyze the company.

You also want access to the company's historical data to see trends in its performance. You can also compare your company's historical data with competitors since they'll likely have similar data.

Use the following three-step approach to holistically analyze a company's profitability:

### Step 1: Perform a break-even analysis

Calculate the break-even revenue and volume. Then subject the break-even analysis to 'what if' planning. Such as, what if the company's total variable cost increases? What if the total revenue decreases? What if the price increases?

Doing so identifies at what points a company no longer breaks even. The business can then take steps to avoid this problem. For example, your break-even analysis may reveal that your company can't break even if your price falls below \$50 per unit. You'll then design your pricing to be at least \$50 per unit.

### Step 2: Ratio analysis

Calculate the profit and return ratios using the above formulas and graph this information over time. The trends will reveal the company's historical performance. You'll also want to correlate trends like increasing orders and an increased profit margin ratio.

The above information indicates the company has entered economies of scale and performs disproportionately better with a high sales volume. This information further means that you want the company to prioritize increasing sales.

### Step 3: Compare your data with competitors

Compare your break-even analysis and ratio analysis with competitors in the same industry. Doing so contextualizes your company's performance within the industry. Each industry has its norms, so only compare with similar companies.

For instance, your business could have a historically stable ROE of 4%. You might find this statistic low in absolute terms. But the industry average is 2%, in which case your company performs better than average. Having finished this article, you should know how to use financial data to perform profitability analysis.

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Ray Wyand, CEO of gini
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