Profitability analysis is a business essential. While this may sound obvious at first, the nuances of generating profit transcend what you see on your financial statements and balance sheets.
Running a profitable business goes beyond earning more than you spend. Your company's profitability may be easy to determine, but in today's competitive business environment, you need to go a step further by analyzing the details of your accounting activities. Be it by Product, Customer, or Location.
The truth is, you may not be making as much as you could be. For instance, you may have one product or division that’s profitable and another that's hemorrhaging money.
A profitability ratio analysis gets down to the nitty-gritty, allowing you to gain operational efficiencies. It's especially beneficial for growing companies as it can help you identify growth opportunities and the business operations that are detrimental to your bottom line.
For a business owner, conducting a profitability analysis provides a more concrete picture of your company.
Profitability analysis is a part of enterprise resource planning that helps you keep track of your business performance and identify opportunities to maximize your profit. Profitability analysis gives you a 360° view of your enterprise’s profits.
Here are several measures of profit you can use to analyze profitability – each providing a different view of your operations.
Margin ratios help you understand your company’s performance during a specific financial period.
Expressed as a percentage of sales, gross profit margin is an analytic measure used to assess a company's financial health. It is determined by the profit earned on sales. It's the amount of money left over after deducting the cost of goods sold from your revenue and can help you identify if your sales are too low or if your operating expenses are too high.
Net margin is a ratio that measures how much net income is generated as a percentage of revenue. As a measure of profit, it can help you identify any cracks in the way you operate since any disturbances in your operations will impact your net profit margin.
This financial ratio looks at earnings as a percentage of generated sales before factoring in income taxes and interest expenses.
The purpose of determining operating profit margin is to determine whether your business has the financial capability to pay fixed costs and interest on obligations. If your margin is high, your company has a better chance of surviving periods of economic slowdown.
Return ratios illustrate an organization’s capacity to generate income for its investors.
ROE is a measure of financial performance that expresses stockholders' equity as a percentage of net income. It's the percentage of earnings shareholders get in return for their investments. For this reason, a high ROE is often cited as an excellent reason to buy a company's stock.
ROA measures the efficiency of your company at utilizing its assets; the higher ROA, the better. It’s expressed as a ratio of net earnings in proportion to an organization’s total assets. Companies with a low ROA are asset-intensive, which means they need a lot of capital investment to generate income.
Unlike Return on Equity, ROA doesn't take your business' debt into consideration. If your company carries no debt obligations, then shareholders' equity would equal the total assets making ROA and ROE the same.
Profitability analysis is often assumed to rely only on profitability ratios. Suffice to say, no one formula can help you generate a growth strategy for your business.
Profitability ratios are a great start, but developing a comprehensive growth strategy requires both qualitative and quantitative analytics to get the whole picture. Sure, the math helps, but every company is different.
What will work for another company in your niche is unlikely to work for yours. There are so many factors to consider beyond the numbers, including geographical location, market conditions, customer behavior, and more. That's why it's crucial to work with a business advisor. Profitability analyses are helpful, but only if you implement the initiatives you generate out of them.
That said, you've come to the right place. BAAP CPA is a CPA firm in Clearwater offering business advisory services for companies like yours. Work with our CPA Firm to understand what your profitability looks like so you can ask more from your finance team and find the right solutions to your growth hindrances. Contact our team today to schedule a free consultation.