Why Is Profitability Analysis So Important?

Originally Published: August 17, 2021
Last Updated: January 31, 2023

Profits keep shareholders and stakeholders happy and provide your company with more capital to grow. To plan an effective course of profit-growing actions that are rooted in data, a profitability analysis matters…a lot.

What is Profitability Analysis?

A profitability analysis looks beyond end net profit for more detailed insights into an organization’s ability to generate income, including:

• Gross & net profits
• Return ratios
• Margin ratios
• Returns of assets, capital employed, and equity

Looking at these in more detail will help maximize profit further by identifying specific areas that can be improved. Your profit analysis will help identify expansion opportunities and market trends and it will give decision-makers the information they need to decide on the company’s direction.

The intent of this blog post is to discuss the profitability analysis definition, and more specifically, the details of a customer profitability analysis which is different from a product line profitability analysis. The customer version looks at the various activities and expenses incurred in servicing a particular customer rather than profit per product. It also provides you with a segmented view of your customers’ profit contribution to your organization.

Why Is Profitability Analysis Important?

With a profitability analysis, you’ll gain a window into how the net profit is broken down. Various factors contribute to the net profit figure and understanding these factors provides insights into how certain aspects of the company are performing. When it comes to your bottom line, net profit isn’t the only important number

How to Conduct a Profitability Ratio Analysis

A profitability ratio analysis prepares analysts and potential investors for how well the company is performing – making a profit from revenue while considering overheads, balance sheets, shareholders’ equity, and so on. This helps to give potential investors an overall picture of how well the business is performing compared to its competitors and gives a strong understanding of the company’s underlying finances.

More specifically, profitability ratios measure and evaluate your organization’s ability to generate income (profit) relative to revenue and costs over a specific period of time. A profitability ratio analysis helps demonstrate how well a company utilizes its assets to produce profit and value for shareholders. The higher the ratio, the more profitable a company is and the more attractive it becomes to potential investors.

Profitability Ratio Analysis Metrics

A profitability ratio analysis will include a look at these metrics:

Margin Ratios

Margin ratios tell how effective a company is at turning the money it makes into profit. This figure lets potential investors know how well a company has performed during a specific period. Margin ratios can be broken down further, including:

• Cash flow margin
• EBITDA (earnings before interest, taxes, depreciation, and amortization)
• Gross profit margin
• Net profit margin
• NOPAT (net operating profit after tax)
• Operating expense ratio
• Operating profit margin
• Overhead ratio

Gross Profit Margin

Gross profit is the value of all the money made from selling products, then subtracting the costs of making those products. This includes costs like office and admin costs as well as materials and transportation, etc.

The gross profit margin is the gross profit figure divided by the total revenue made from selling their products and multiplied by 100. This percentage is the ratio of profit you are making from your sales.

Of course, continuously high gross profits make you more money. The gross profit margin is also important to incorporate into your financial analysis. If your profit margin is less than around 10% this is a warning sign that you should perform cost-cutting and process improvement measures to boost efficiency.

Net Profit Margin

Your net profit is perhaps the most important of all profitability metrics.

Simply put, it means how much money you have left after all expenditures including taxes, interest, and operational expenses.

The net profit margin is calculated in a similar way to the gross profit margin. Net profit divided by the total revenue, then multiplied by 100 is the percentage that depicts how much of the money you keep after all costs.

The metric helps to identify weaknesses in the business that inform better business decisions to help improve overall profits.

Return Ratios

The return ratio tells how well a company can make returns for its shareholders. Return ratios can be broken down into further categories, including:

• Cash return on assets
• Return on assets
• Return on debt
• Return on equity
• Return on retained earnings
• Return in invested capital
• Return on revenue
• Risk-adjusted return
• Return on capital employed

Return on Assets and Returns on Capital Employed

These profitability metrics tell a company how effectively they are using the resources at their disposal. Return on Assets (ROA) is how much revenue a company has made against the value of the assets owned by the company.

Returns on Capital Employed (ROCE) show how much revenue a company is making against how much money is being used to operate the business. The higher the ratio, the more efficiently a company is operating. A low ratio means the company needs to look into improving efficiency to keep the business healthy.

Return on Equity

The Return on Equity metric illustrates how much shareholders expect their return to be on their investment. Thus, the goal is to keep this figure high and encourage further investments.

Behind every net profit figure is a wealth of metrics that will inform better insights and decision making. A profitability analysis provides the details necessary to fully understand an organization’s ability to generate income. It provides how well a company is performing ‘under the hood’ and it helps to identify where the company is doing well, and where gaps exist. Once problem areas have been identified, senior management then makes decisions regarding business operations to help keep the company healthy.

The analysis is also important for potential shareholders who will be looking for healthy businesses to invest in. A robust profitability analysis encourages further investment, helps to improve capital, and keeps the business performing at a high level.

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Key Takeaways

Consider these key takeaways before conducting your own profitability analysis:

• A customer profitability analysis is different from a product profitability analysis. It looks at the various activities and expenses incurred in servicing a particular customer and provides a segmented view of who is contributing what to your organizational profit.
• A profitability ratio analysis prepares analysts and potential investors for how well the company is performing compared to competitors.
• Profitability ratios measure and evaluate your organization’s ability to generate income (profit) relative to revenue and costs over a specific period of time. Commonly relied upon key profitability metrics include: Gross Profit Margin, Net Profit Margin, Margin Ratios, Return Ratios, Return on Assets, Return on Capital Employed, and Return on Equity.
• Organizations will learn how well they are doing ‘under the hood’ with a profitability analysis and potential shareholders can better understand and therefore invest.