Profitability Analysis for Businesses- 7 Types
To operate successfully in the long term, companies need to maintain and continuously scale their profits. Management teams can make sure they are on the right track by regularly conducting a profitability analysis.
This insight not only gives businesses a better understanding of their bottom line, but also the means necessary to identify their consumer base and demonstrate their profitability to investors.
What is a Profitability Analysis?
Profitability analysis is the practice of examining the profitability of a business's current output and forecasting potential profits and sales.
Typically measured as ratios, a profitability analysis can provide great insight into customer demographics, successful products or services, and improvements that need to be made to increase profit margins. These measurements will also demonstrate how well a company is utilizing its assets during a given period.
Profitability ratios are often divided into two classifications - margin ratios and return ratios.
Margin ratios refer to metrics that indicate how well a business can produce a profit, while return ratios represent a company's efficiency in managing investments and its ability to generate returns to its shareholders.
7 Methods to Measure Profitability
To effectively measure a business's profitability, management teams must regularly calculate their ratios and monitor their trends. The 7 profitability ratios that business owners should assess are-
1. Gross Profit Margin
The gross profit margin ratio demonstrates the percentage of revenue that a business retains after operating and inventory costs are deducted. Generally, companies will want a large gross profit margin because it indicates how well they can control production costs.
To calculate this ratio, organizations must first determine their gross profit, which can be done by subtracting the cost of goods sold from sales. Managers can then use the formula-
- Gross Profit Margin = Gross Profit / Sales
For example, if a company's total sales are $100 and the costs of goods sold is $40, the gross profit is $60. Management can plug this into the formula-
- Gross Profit Margin = $60 / $100
- Gross Profit Margin = 0.6
This means that the business's gross profit margin is 60%
2. Operating Profit Margin
Also known as earnings before interest and taxes (EBIT) margin, operating profit margin reflects how much profit a business made after daily operating activities, such as wages, are deducted.
To calculate the operating profit margin, managers can use the formula-
- Operating Profit Margin = Earnings Before Interest and Taxes (EBIT) / Sales
For instance, if a company's income statement indicates its EBIT is $20 and sales are $100, the calculations would look like this-
- Operating Profit Margin = $20 / $100
- Operating Profit Margin = 0.2
The business's operating profit margin ratio would therefore be 20%.
3. Net Profit Margin
Net profit margin ratios are most commonly used by businesses to gauge their financial performance. The measurement indicates how much money from sales remains after all expenses, such as taxes and interest, are deducted.
Companies can calculate their net profit margin with the formula-
- Net Profit Margin = Net Income / Sales
A business that has $50 in net income and $100 in sales can plug these values into the formula-
- Net Profit Margin = $50 / $100
- Net Profit Margin = 0.5
Therefore, the company's net profit margin is 50%.
4. Cash Flow Margin
Cash flow margin ratios are indicative of how well sales are transformed into cash. This is important because businesses need to have cash so they can pay suppliers and dividends, and invest in new assets.
This ratio can be calculated with the formula-
- Cash Flow Margin = Cash Flow from Operating Activities / Net Sales
If the cash flow margin is high, this means businesses have more cash available. For example, if a company's cash flow from operating activities is $450,000 and their net sales in a given period are $750,000, their calculations would be-
- Cash Flow Margin = $450,000 / $750,000
- Cash Flow Margin = 0.6
This company has a cash flow margin ratio of 60%, which means its profitability is high.
5. Return on Assets
A return on assets ratio shows how efficient a business is in controlling its investments in assets and utilizing them to generate earnings. This percentage can be calculated with the formula-
- Return on Assets = Net Income / Total Assets
Companies can find their net income and total assets values on their financial statement. For instance, if it indicates that they have a net income of $5,000 and total assets of $50,000, the calculations would be-
- Return on Assets = $5,000 / $50,000
- Return on Assets = 0.1
This means the company's return on assets ratio is 10%. Generally, organizations will want a higher percentage because it indicates their efficiency in using assets to create sales.
6. Return on Equity
Return on equity is highly important to investors because it measures how much profit the company will generate from its shareholders' investments. Potential investors will commonly examine this ratio before they decide to put capital into a business.
This ratio can be calculated with the formula-
- Return on Equity = Net Income / Shareholder's Equity
Typically, a high percentage shows that a company is making high levels of profit with an investor's money. To illustrate, if an organization has $10,000 in net income and its shareholder equity is $20,000, the return on equity calculations would be-
- Return on Equity = $10,000 / $20,000
- Return on Equity = 0.5
This means the company has a 50% return on equity.
7. Cash Return on Assets
A cash return on assets ratio demonstrates profitability by showing how efficient a company is in producing cash from its asset investments.
To calculate the ratio, businesses can use the formula-
- Cash Return on Assets = Cash Flow From Operating Activities / Total Assets
Organizations can find these values in their financial statements, such as the balance sheet and the statement of cash flows.
For example, if records show that a business has $23,000 in cash flow from operating activities and $90,000 in total assets, their calculations would be-
- Cash Return on Assets = $23,000 / $90,000
- Cash Return on Assets = 0.25
Therefore, this business's cash return on assets is 25%.
By frequently monitoring these ratios and conducting profitability analyses, management teams will be able to identify positive and negative trends. This insight will equip executives with the data necessary to make informed decisions to protect their bottom line.