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Why Is Profitability Analysis So Important?

Vendavo< Vendavo August 17, 2021

The short answer? Profits keep stockholders and stakeholders happy and give your company more capital to invest and expand. So profitability analysis matters…a lot.

But the bottom line – the net profit – isn’t the only number that matters. Businesses need to look beyond the end figure and analyze how that figure can be broken down, by thinking about:

  • Both gross & net profits 
  • Returns of assets, capital employed and euity
  • Return ratios
  • Margin ratios

Looking at these figures in more detail will help to maximize profit further by identifying areas that can be improved. It can help look for opportunities to expand into, identify market trends, and give decision-makers the information they need to decide on the company’s direction.

Why Is Profitability Analysis Important?

Profitability analysis gives a company a window into how the net profit is broken down. Various factors contribute to the net profit figure and understanding these factors will give a better idea of how certain aspects of the company are performing.

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. Multiplied by 100, it gives you a percentage figure that tells you 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% then that is a warning sign that you should cost-cutting and process improvement to boost efficiency. 

Net Profit Margin

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

Simply put, it means how much money you have left after all expenditures including taxes, interest, and operation 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 tells you how much of the money you keep after all costs. 

The net profit margin figure is another metric that helps to identify weaknesses in the business that inform better business decisions to help improve overall profits.

Return on Assets and Returns on Capital Employed

The 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.

Returns on Equity

The Returns on Equity metric illustrates how much shareholders are expected as a return on their investment. Thus, keeping this figure high will help encourage more investment.

Profitability Analysis

Profitability Ratio Analysis

A profitability ratio analysis prepares analysts and potential investors for how well the company is performing – making a profit from revenue and taking into account 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. The higher the ratio, the more profitable a company is and the more attractive it becomes to potential investors.

A profitability ratio analysis will look into some other metrics concerning the profits of a company, some of which include:

Return Ratios

The return ratio tells how well a company is able to 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
Margin Ratios

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

Conclusion

A profitability analysis report will tell us how well a company is performing “under the hood“. It helps to look at finances in finer details that help 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 health profitability analysis will encourage further investment, helping to improve capital and keep the business performing healthily.