What is profitability analysis?
Profitability analysis is an essential way for a business to determine how much money it can make. It is an integral part of an enterprise resource planning (ERP) system that helps business leaders make the most of their plans, projects, and goods.
The profitability analysis method looks at the company’s profits from all of its different sources of income in a planned way. It uses quantitative and qualitative data to fully understand how well the business is doing financially.
Synonyms
- Profit analysis
- Profitability ratios
Why profitability analysis is important
When you look at revenue, you need to do more than find the bottom line. It tells you a lot about a company’s overall financial health and considers things like customer demographics, location, and the types of products that will best fit your market. It also talks about relationships with suppliers and customers, and you can use it to handle these relationships well.
Here are a few reasons why you should make profitability research a big part of your business plan:
- Figuring out what makes a profit
- Improving the mix of products
- Making it easier to make decisions
- Keeping track of prices that don’t change
- Finding places where costs can be cut and productivity can be raised
- Looking at the profit margins for each of your buyer groups
- Comparing yourself to competitors and business standards
- Getting investors and other partners to trust you more
- Figuring out where to grow and expand
- Budgeting and planning your finances
To make the most money, you may decide to cut costs, spend more, or streamline processes based on the results of your research. You’ll also use it with other types of financial analysis, such as cost-volume-profit (CVP) analysis, to guess how money will do in the future.
How Business People Use Profitability Analysis
Businesses use a few main parts and ways to figure out how profitable their products are:
Ratios of Profitability
These financial measures show how well a business can make money over time compared to its costs, assets, and equity. Gross to-net profit margin, operating profit margin, and return on assets/equity are some of the most well-known profitability measures.
Analysis of Customer Profitability
Using the CAC payback and customer lifetime value metrics, this method looks at transaction data to determine which customers are the most and least profitable and what actions cause those results. It also means checking out which items and mixes of products are bought the most.
Analysis of Qualitative Data
This means looking at the market and how customers act to find patterns and trends to help you make better strategy decisions. For instance, looking at what customers say about your goods and services can help you find ways to improve them and run your business more efficiently.
Analysis of Break-Even
This is one of the most basic ways to determine when a business’s income equals its costs. This helps figure out how much money the business needs to stay open. You need to do more than break even to make a profit. The goal of a break-even study is to figure out how many units you need to sell to make a profit.
Comparing Profitability Ratios by Industry
Business owners can figure out how they stack up against the competition by comparing their company’s profitability ratios to the averages for their field. Most of the time, companies in the same business that are similar should have similar profitability ratios. In this case, the Rule Of 40 says that SaaS businesses should have a profit margin and sales growth rate of 40% or more.
Methods for Analyzing Profitability
In real life, a profitability analysis usually involves getting financial documents like balance sheets and profit-and-loss accounts, figuring out different profitability metrics, and then comparing the outcomes to better understand how things are going. This also means figuring out what makes a business profitable and using that information to make intelligent choices.
Analysis of Break-Even
Break-even analysis aims to find the point at which a business or new project will start making money. At this point, the total amount spent and earned are equal, meaning there is no net gain or loss. The business has paid all its bills but hasn’t made any money yet. This is called “break-even.”
Some critical parts of break-even analysis are:
1. Fixed costs are rent, pay, and insurance that don’t change based on how much is made or sold.
2. Costs that change based on how much is being made, such as the cost of raw materials and direct work.
3. Revenue per unit is how much you make when you sell one item.
From there, here’s how to figure out the break-even point:
Break-Even Point (units) = Fixed Costs / (Price per Unit – Variable Cost per Unit)
Break-even analysis is an essential part of planning and managing money, especially when a business is starting or a new product is being released. It gives a clear picture of what needs to happen to make money and helps people make smart financial choices.
Analysis of Ratios
Ratio analysis is a type of financial analysis that looks at different parts of a business’s operating and financial success. It includes figuring out and understanding financial ratios and mathematical comparisons of accounts and categories in a financial statement. They are on your income statement, cash flow statement, and balance sheet.
- Liquidity ratios show how well your company can pay its short-term bills. The current ratio and the quick ratio are two examples.
- Profitability ratios show how well your company can make money compared to its income, business costs, and owners’ equity. Your gross/net profit margin and return on assets/equity are two common examples.
- An efficiency number shows how well a business uses its assets and debts. Inventory turnover and accounts payable turnover are two examples. You can use them to determine how well a business uses its assets to make money.
- Solvency rates show how well you can pay and handle your long-term debts. Some examples of solvency ratios are the debt-to-equity and interest payment ratios.
- Valuation numbers help determine how much your business is worth on the market. The price-to-earnings (P/E) ratio and the price-to-book ratio are two common ways to value a business.
Analysts, investors, and creditors use ratio analysis to help them make choices that will affect the company’s future. Often, they’ll look at success over time (trend analysis) or compare it to other businesses in the same field (comparative analysis).
However, it is essential to use ratio analysis along with other types of financial analysis since ratios may not give a complete picture of a company’s financial health.
Metrics Related to Profitability
Gross Margin of Profit
Gross profit margin tells you how healthy your business is financially by showing you how much money is left over from sales after the cost of goods sold (COGS) is considered. It shows much about how well a company makes things and sets prices.
Take your total revenue and remove your cost of goods sold (COGS). Then, divide this number by your total revenue to get your gross profit margin. This is the formula:
Gross Profit Margin = [(Revenue – COGS) / Revenue] x 100
After considering the cost of goods sold, the result is a percentage that shows how much of your overall revenue is left over for running and growing the business.
Margin of net profit
The net profit margin tells you how much money a business makes compared to how much money it makes in sales. To find it, divide the net profits (after taxes and deductions for costs) by the total income.
To find your net profit margin, you’ll need to know how much you spend on rent, staff salaries, and running the business.
This is the formula:
Net Profit Margin = (Net Income / Total Revenue) x 100
Gross profit margin tells you how much of your income is left over after costs of goods sold (COGS are taken into account), but net profit margin gives you a fuller picture by including all your other costs. The first would help you determine how efficient your production is, and the second would help you figure out how well you can make a profit overall.
Operating Income Margin
Another critical measure of a business’s profitability is its running profit margin, which considers all of its costs (except for taxes and interest) and shows how efficiently it runs. It shows how much money is left over after all costs are subtracted from the total income but before non-operational costs are considered.
This is the formula:
Operating Profit Margin = Operating Income / Net Sales x 100
If your running profit margin is high, your business is making a good profit, and you have enough left over to pay for other costs. A low running profit margin could mean you’re not charging enough or your operational costs are too high.
Cost of Goods Sold (COGS)
The return on assets (ROA) tells you how well a business uses its assets to make money. Put another way, it shows how much money is made for every dollar of owned goods.
Divide your net income by your total assets and then increase the number by 100 to get your ROA.
Return on Assets = (Net Income / Total Assets) x 100
When you buy a new piece of equipment, for example, you can use ROA to figure out how well the extra money makes up for the purchase cost.
How Much Money You Made (ROE)
Return on equity measures how well a business uses its shareholders’ money to make money. The percentage of profit a company makes as a share of its owners’ equity is an essential number for investors and shareholders.
Divide your net income by your shareholder stock and then multiply the number by 100 to get your return on equity (ROE). This is the formula:
You get a return on equity when you multiply net income by shareholder equity.
A high ROE is usually seen as a good thing because it means the company gives its owners a good return. But when looking at ROE, it’s also essential to consider how much debt the business has. It’s possible for a business with a high ROE also to have a lot of debt, which could be harmful in the long run.
Gain for Each User
Average margin per user (AMPU) is a subscription statistic that media, telecom, and SaaS companies use to determine how profitable their services are. To find it, divide the total operating earnings from a specific period by the total number of subscribers.
AMU stands for “average margin per user.” It is calculated by dividing operating income by the average number of subscribers over some time.
Margin per user is based on a simple idea: your business can handle low total sales by lowering operational costs and increasing margins. This tool can also be used to see how profitable different subscription levels, goods, and billing models are.
Steps for a Profitability Analysis
Set business goals and targets.
First, you need to figure out what you want from your profitability study. Are you trying to determine how well a particular product or service works? Want to figure out how healthy your company’s finances are?
It’s not enough to look at numbers. It would be best if you thought about how the things you do for your business affect your bottom line and whether there are any problems or flaws that need to be fixed.
Collect financial records and other valuable details.
You’ll need the following to do a business analysis:
- Your profit and loss page
- The cash sheet for your business
- The balance sheet of a competition from the same period
You’ll also need to gather business-specific financial data, such as the prices of goods and services, sales data (per channel), and any non-financial data that could affect the business’s ability to make money.
See where the money comes from and where the costs go.
Your income drivers will differ depending on the business type you run. Some examples are
- Delivery of goods or services
- Sales of subscriptions
- Getting ads
- Agreements to lease and rent
- Partners in sales channels
Once you know where your money is coming from, you must figure out where it’s going. Most of the time, this has to do with creating or keeping a product, the supply chain, or the production of a product.
Figure out the most important profitability analysis ratios and measures.
Figure out the following using the above formulas:
- Gross margin of profit
- The net profit margin
- Margin of operating profit
- ROA, or return on assets
- ROE, or return on equity
- Amount per user
After that, make a spreadsheet where you can put the results of your study. After that, you can also compare them to those of your competitors.
Read the results and make choices based on what you know.
Your FP&A team should be able to understand the data and give you helpful information. They’ll be able to show you where you can save money, make your business run more smoothly, and make more money. It’s essential to know a lot about your financial success to make decisions that will help your business grow over time.
The best ways to do a profitability analysis
Once every three months, look at how profitable things are.
It’s best to do monthly revenue analyses, which is how often you’ll need to look at your data when making your financial plan. If, for some reason, that’s not possible, then at least try to do it every three months.
Figure out several different profitability rates.
Don’t just look at the gross profit margin, the net profit margin, or the working profit margin to figure out how profitable your business is. All three are essential. Instead, figure out different measures and ratios to get a complete picture of how your business is doing financially.
Don’t forget that you will use each number for a different reason.
- Do you want to know how well you’re keeping costs down? Take a look at your gross profit.
- Do you want to know if your pricing plan works? Take a look at your net profit.
- Do you want to find out how well your business process works? Check out the margin of your running profit.
Not only one kind of financial model should be used,
Valuation models and break-even analysis can also tell you a lot about how profitable your business is. These models look at different growth scenarios and help you figure out how they might affect your bottom line.
Also, it’s important to note that danger isn’t considered in profitability analyses. The possible return on investment isn’t always clear, and it might not happen for years. This might not be shown correctly in the more objective results of a profitability study.
Don’t stop at allocation.
When you assign prices to specific business units or products, this is called “proportionation.” You could, for instance, give each product a certain amount of extra cost based on how many units were made.
This might be the quickest way to determine if something is profitable, but it might not be the best way. This is because apportionment thinks these units are responsible for all secondary costs, which might not be accurate.
Instead, you might want to use activity-based costing to divide the prices based on how each product uses resources. You can also use traffic accounting to find out how the flow of products affects your bottom line.
Don’t forget that sometimes less is more.
If you focus too much on short-term profits, you might not be able to make the best decisions for the long-term growth of your business. Don’t forget that success isn’t just about making money right now; it’s also about making sure you can grow and stay in business in the future.
You might work on a business project that won’t make you money right away (or ever) for several reasons.
- You could use it to get an edge over your competitors
- It might be essential to keep good customers.
- In the long run, it might make things run more smoothly and save money.
- Your business may decide to keep it as a part of its brand.
