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What Is Profitability Analysis and Why Is It Important to Businesses?


IBISWorld offers a range of key ratios, including profitability, for thousands of industries across the globe. This article aims to breakdown the extensive subject of profitability analysis, what can be inferred from this and how analysis between industries may differ.

Following the inception of a company, one of the primary objectives it is to generate a profit. The basic understanding of this, is for the company to earn more than it spends. Therefore, to assess the growth of your business, careful analysis with regards to profit is important. However, the nuances that lie under financial statements will provide a more detailed understanding of a company’s profit.

What is profitability analysis?

Profitability analysis assists business leaders with identifying methods to optimise profitability as it relates to various projects, plans or products. It is the process of systematically analysing profits derived from the various revenue streams of a business.

Typically, profitability analysis is incorrectly assumed to exclusively rely on profitability ratios. In reality, it relies on both qualitative and quantitative analytics to assist business leaders in understanding the entire perspective. While profitability analysis does provide clarity for many quantitative questions, it is unique in that it can also help business leaders identify which information sources are most factual and reliable.

Why is profitability analysis important?

There are numerous reasons as to why the understanding of the quality of a business’ earnings is important.

Firstly, in order for a company to maximise profit, business leaders need to understand the drivers behind their profits. This helps to create efficiencies in revenue-generating processes and activities. As a result, it forces a business to continually discover methods to reduce overheads and other costs that affect profitability.

Secondly, profitability analysis helps to identify methods to enhance product mixes to maximise near- and long-term profit. This assists the budgeting of a business by enabling operators work to create reasonable goals and work out how these will be achieved.

The ability to identify both short- and long-term product mixes also supports management team in determining what modifications, if any, need to be made to the company.

A consequence of the profitability analysis is the ability to foresee future sales and provide insight into customer demographics, geographic locations and product types that can be used to assess potential profit. This allows businesses to observe the profitability of each product, which can help operators choose to eliminate specific products.

Finally, profitability analysis scrutinises the relationships with customers and vendors. This identifies which customers are the most and least profitable and which vendors have the biggest influence on profitability. This is crucial when balancing relationships between the customers and vendors.

Profitability ratios

Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate profit relative to its revenue, balance sheet assets, operating costs and shareholders’ equity during a specific period of time.

A higher ratio or value is typically desirable for the majority of businesses, as this usually means the company is performing well by generating revenue, profit and cash flow. The ratios are most useful when they are analysed in comparison with the wider industry in which a company operates or compared with previous periods for the same operator.

There are typically two types of profitability ratios: margin ratios and return ratios. Margin ratios represent a business’ ability to convert sales into profit at various degrees of measurement. Return ratios represent a business’ ability to generate returns to its shareholders.

Gross profit margin

The gross profit margin shows revenue after subtracting the cost of goods sold involved in production. The cost of goods sold is the amount it costs a company to produce the goods or services that it sells. The gross margin is indicative of how well a business generates revenue from the direct costs, such as direct labour and materials involved in producing products and services.

Gross profit margin=(Revenue-cost od goods sold)/Revenue

Operating profit margin

The operating profit margin assess earnings as a percentage of sales before interest expenses and income tax are deduced. Businesses with high operating profit margins are generally better equipped to pay for fixed costs and interest on obligations, have better chances to survive an economic slowdown and are more capable of offering lower prices than their competitors that have a lower profit margin.

Operating profit margin=Operating income/revenue

The operating profit margin is commonly used to evaluate the strength of a business’ management, as good management can significantly improve the profitability of a business by managing its operating costs.

Net profit margin

Net profit margin provides the final picture with regards to how profitable a business is after all expenses, including interest and taxes, have been taken into account. A reason to use the net profit margin when analysing profitability is that it takes everything into account, including the expenses. A disadvantage of using net profit margin within analysis, is that it includes a lot of irregular variables which can often dictate a trend, such as one-time expenses and gains, which makes it harder to compare a business’ performance with its competitors within its industry.

Net profit margin=(Revenue-expenses)/Revenue

Cash flow margin

The cash flow margin expresses the relationship between a company’s cash flows from operating activities and sales (or revenue). It measures a business’ ability to convert sales into cash. The higher the percentage of cash flow, the more cash available from sales to pay for suppliers, dividends, utilities and service debt, as well as to purchase capital assets.

Cash flow margin = (Cash flow from operating activities/revenue)

However, negative cash flow, means that even if the business is generating sales or profits, it may still be losing money. In the instance of a company with inadequate cash flow, the company may choose to borrow funds or to raise money through investors in order to maintain operations.

Having previewed the definition and calculation used for the cash flow margin, we will now take a look at two different industries. Industry-specific cash flow margins can be found within IBISWorld’s Industry Financial Ratios.

In 2020-21, the Full-Service Restaurants industry in the UK had a cash flow margin of 11%, while the Hotels industry had a superior cash flow margin of 28% over the same year. However, profitability ratios are often better used when assessing the same industry over time or an individual company compared with the wider industry.

The management of cash flow is vital if a business wishes to succeed. This is because regularly having sufficient cash flow both minimises expenses and enables a company to take advantage of any extra profit or growth opportunities that may arise. For example, a business with a healthy cash flow can avoid late payment fees, while also seizing an opportunity to purchase at a substantial discount the inventory of a competitor if it goes out of business.

Return on equity

Return on equity (ROE) expresses the percentage of net income relative to shareholders’ equity or the rate of return on the capital that equity investors have put into the business. The ROE ratio is one that is particularly watched by stock market analysts and investors.

Return on equity

A favourably high ROE ratio is often cited as a reason to purchase shares or ownership of a business. Companies with a high return on equity are usually more capable of generating cash internally and therefore less dependent on debt financing.

Return on invested capital

Return on invested capital (ROIC) is used to assess a business’ efficiency at allocating the capital under its control to profitable investments. It is also a measure of the return generated by all providers of capital, including both bondholders and shareholders. It is similar to the ROE ratio but more all-encompassing in its scope, since it includes returns generated from capital supplied by bondholders. ROIC provides a sense of how well a company is using its capital to generate profits.

Return on invested capital = (net income - dividends / (debt+equity)

A disadvantage of using ROIC is that it provides no insight with regards to what segment of the business is generating value. When making the calculation based on net income minus dividends, the result can be even more unclear, since the return may derive from a single, non-recurring event.

Return on capital employed

Return on capital employed (ROCE) is a profitability ratio that measures the efficiency of a business in using its capital to generate profit. In other words, this ratio can help to understand how well a company is generating profits from its capital as it is put to use.

Return on capital employed = (Earnings before interest and tax) / (Total assets - current liabilities)

ROCE can be especially useful when comparing the performance of companies in capital-intensive industries, such as the Electricity Production and Wired Telecommunications Carriers industries. This is because, unlike other fundamentals such as ROE, which only analyses profitability related to a company’s shareholders’ equity, ROCE considers debt and equity. This can help neutralise financial performance analysis for companies with significant debt.

Return on total assets

Return on total assets (ROTA) measures a business’ earnings before interest and taxes (EBIT) relative to its total net assets. It is defined as the ratio between net income and total average assets, or the amount of financial and operational income a company receives in a financial year compared with the average of that company’s total assets.

Return on total assets = (Earnings before interest and tax)/ Average total assets)

ROTA is considered to be an indicator of how effectively a business is using its assets to generate earnings. EBIT is used instead of net profit to keep the metric focused on operating earnings without the influence of tax or financing differences compared with the company’s industry.

The greater a business’ earnings in proportion to its assets, the more effectively that business is said to be utilising its own assets. ROTA therefore allows an organisation to assess the relationship between its resources and its income.

In terms of limitations when using ROTA, the value of an asset may diminish or increase over time. In the case of the property or real estate, the value of the asset may rise. On the other hand, most mechanical pieces of a business, such as vehicles or other machinery, generally depreciate as wear and tear affects their value. As aa result, the usefulness of ROTA may vary between industries dependent on the assets owned.

Having previewed the ROTA formula and what it entails, let’s take a look at two different industries. Industry-specific ROTA can be also found within IBISWorld’s Industry Financial Ratios.

In 2020-21, the Residential Building Construction industry in the UK had a ROTA of 23%, whereas the Newspaper Publishing industry had a ROTA of 4% over the same year. While there are some limitations to using ROTA, assessing these figures we can state that during 2020-21, the Residential Building Construction industry utilised its assets more effectively than the Newspaper Publishing industry. However, profitability ratios are often better used when assessing the same industry over time or an individual company compared with the wider industry.

Other profitability analysis methods

While we have primarily focused on profitability ratios as a tool used within profitability analysis, there are other forms of analysis methods that deserve an honorary mention. These include customer profitability analysis (CPA) and qualitative analysis.

CPA allows businesses to determine the overall profit a customer generates. Profitable customers generate revenue greater than the cost of their acquisition, selling and serving. When businesses are more focused on products, departments and locations of offices, they often tend to lose focus on the customers. As a result, these businesses often have to bear the cost of maintaining unprofitable customers, which is detrimental to the company.

Annual profit = (Total annual revenue generated by the customer) / (total annual expenses incurred to serve the customer)

CPA enables companies to evaluate their customers and know how beneficial it is for them to keep the customers. Based on this, they can decide upon the cost of serving them or even to whether to keep them as a customer. It has been proved that the size of a customer is not directly proportional to its profitability. It is not uncommon that even the largest customers can turn out to be unprofitable for a business.

The qualitative analysis used within the parameters of profitability is a research tool used by businesses to analyse an organisation’s overall value based on non-quantifiable indicator. In contrast, the non-quantifiable indicators can be information on items within an organisation, such as their industry cycle, management expertise, responsiveness to inquiries, strength of business functions, labour relations or even their visibility within media.

Qualitative analysis differs from quantitative analysis in terms of measurement. The former measures non-numeric information, while the latter measures numerical data such as numbers on an income statement, balance sheet or cash flow statement.

In the majority of cases, both qualitative and quantitative analysis will be used together in order to extensively examine a business’ trajectory and potential, both of which are incredibly important indicators used to determine investment opportunities.

Using profitability analysis

You’ve made it to the end. Congratulations! Now it’s time to start putting profitability analysis to work.

If you’ve learned anything from this guide, it’s that some profitability ratios are cut and dry while others come with a few caveats. More often than not, evaluating profitability analysis through ratios means looking at sector- or industry-level benchmarks to make fair conclusions about a company.

Where do these profitability ratios come from?

We’ve mentioned a few common profitability ratios for specific industries or sectors, but there are a vast number of industries and sub-industries out there, making for lots of variation. Luckily IBISWorld has you covered with thousands of Industry Research Reports that offer the key financial ratios you need.

Source from IBISWorld

Disclaimer: The information set forth above is provided by IBISWorld independently of Alibaba.com. Alibaba.com makes no representation and warranties as to the quality and reliability of the seller and products.

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