Profitability Analysis
It is indeed very important to regularly be able to analyze not just the actual profitability of the business but also different components that become significant factors of profitability analysis
Top firms world-wide have separate departments within the organisation for timely assessment of business profitability and presentation of the same to the top management. Some firms have also outsourced the same to top finance firms such as Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers.
While reporting a periodic profit & loss account along with profitability analysis, there are numerous factors that need to be properly highlighted. Following are the five essentials that need to be considered :
1) PROFITABILITY RATIOS [top]
Here are the profitability ratios that small business owners should look at regularly:
- Gross Profit Margin Ratio – Gross profit margin is a measure of a company’s profitability, calculated as the gross profit as a percentage of revenue. Gross profit is the amount remaining after deducting the cost of goods sold (it is the price of the goods, including inventory or raw materials and labor used in production, but it does not include selling or administrative expenses) or direct costs of earning revenue from revenue. It is important to analyse this ratio in order to analyse whether the business is in profit after covering its direct costs & cost of inventory. A business needs to have a high gross profit margin to be able to cover its indirect expenses and retain net profitability. Without an adequate gross margin, a company will be unable to pay its operating and other expenses and build for the future.
- Operating Profit Margin Ratio – Operating Profit Margin is a profitability or performance ratio that reflects the percentage of profit a company produces from its operations, prior to subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue and expressing as a percentage. The margin is also known as EBIT (Earnings Before Interest and Tax) Margin. The difference between gross & operating margin is that gross profit margin only figures in the direct costs involved in production, while operating profit margin includes operating expenses like overhead. It gives the management an idea whether the business is profitable after covering all of its operating cost that are required to keep the business going. A sound operating profit margin reflects that business can sustain in the longer run since it is able to cover the expenses that are required to keep the business running.
- Net Profit Margin Ratio – Net profit margin is the percentage of revenue remaining after all operating expenses, interest, taxes and preferred stock dividends (but not common stock dividends) have been deducted from a company’s total revenue. This tells whether the firm is profitable on an overall basis or not.
2) BREAK-EVEN ANALYSIS
The term “break-even analysis” is another phrase which may seem complex, but the concept behind it is actually quite simple.
Remember that break-even is the point at which revenues equal expenses. Until your company reaches break-even, you are generating red ink; your costs for materials, labor, rent and other expenses are greater than your gross revenues. Once you pass the break-even point, revenues exceed expenses. After break-even, a portion of each dollar of sales contributes to profits. It is only when you pass break-even that profits begin to be generated.
Break-even analysis is a simple but effective tool you can use to evaluate the relationship between sales volume, product costs and revenue.
It is certainly useful for you to calculate your company’s current break-even point. If your company is profitable you may want to know how much breathing room you have, should revenues take a dip. If your company is losing money, knowing the break-even point will tell you how far you are from beginning to turn a profit.
In addition to evaluating your present situation you can, and should, also use break-even analysis for profit planning.
3) CALCULATING RETURN ON ASSETS AND RETURN ON INVESTMENT (linking both the ratios)
Return on total assets is a ratio that measures a company’s earnings before interest and taxes (EBIT) against its total net assets. (EBIT/total net assets)
It is an important indicator of the asset intensity of a company. A lower ratio means a company is more asset-intensive, and vice versa. Additionally, a more asset-intensive company needs more money to continue generating revenue. Return on asset ratio is useful for investors to assess a company’s financial strength and efficiency to use resources. Since there is always an opportunity cost of investing funds, gradually as a company starts to invest more funds, it needs to ensure that a return equal to at least the required rate of return on investment is achieved to cover the opportunity cost and also be able to have a sound RETURN ON NET ASSETS RATIO.
If the return you are receiving on the money invested in your company does not at least equal the return you would receive from a risk-free investment (such as a bank CD), this is not a viable approach.
4) Fixed Costs
A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or services produced or sold. Fixed costs are expenses that have to be paid by a company, independent of any specific business activities.
Companies can associate both fixed and variable costs when analyzing costs per unit. As such, cost of goods sold can include both variable and fixed costs. Comprehensively, all costs directly associated with the production of a good are summed collectively and subtracted from revenue to arrive at gross profit.
Economies of scale can also be a factor for companies who can produce large quantities of goods. Fixed costs can be a contributor to better economies of scale because fixed costs can decrease per unit when larger quantities are produced. Fixed costs that may be directly associated with production will vary by company but can include costs like direct labor and rent.
Since fixed cost is a sunk cost & mostly irrelevant in decision making (until the organization decides to include fixed portion of costs as well in deciding the price of the product which is only applicable when the market/industry does not set the price of the product, otherwise a target costing approach is followed and companies are required to decide the profit first and then be efficient enough to achieve it) it is important to keep an eagle’s eye on fixed costs since fixed costs put a business in troubled waters during rough times as the cost is not proportionately dependent turnover (like variable costs) and have to be incurred irrespective of the scale of business.
5) Liquidity Ratios
Liquidity ratios are an important class of financial metrics used to determine a debtor’s ability to pay off current debt obligations without raising external capital. These ratios measure a company’s ability to pay debt obligations and its margin of safety.
– Current ratio = current assets/current liability .
The greater the current ratio, the better it is since, current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year.
– Quick Ratio = quick assets/current liabilities (only includes assets that are highly liquid, and does not include stock)
The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the “acid-test ratio”.
– Interest Earned Ratio =EBIT/Total interest charge.
The interest earned ratio is a measure of a company’s ability to meet its debt obligations based on its current income.
It is a ratio which tells that company is easily able to meet its interest cost through its operating income.
– Debt Equity Ratio = debt/equity
The debt-to-equity ratio shows the proportions of equity and debt a company is using to finance its assets and it signals the extent to which shareholder’s equity can fulfill obligations to creditors, in the event a business declines.
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