Profitability analysis: slicing the pie

What is profitability analysis?

Profitability analysis is a deep dive into how and where a company makes profits so that it can assess the most and least profitable parts.

This is super important for financial planning and analysis, allowing FP&A teams to accurately project different parts of the business. Studying a company's ability to generate profits helps the team get better at forecasting and creating stronger, more accurate models, too.

It’s one of five main groups for financial ratios and is part of Enterprise Resource Planning, a software system to manage and oversee the essentials of a company. Financial statements, like the income statement and balance sheet, provide the figures needed for the ratio analysis.

Different metrics look at the fixed and variable costs that affect profitability. Combined, they create a useful view of the organization’s financial health.

Here are some common metrics you'll want to have on hand:

• EBITDA and EBIT
• COGS
• Net sales
• Net profit
• Net revenue

Why is profitability analysis important?

‘Profit’ is a big concept. Looking at the different figures that generate income can reveal a lot more about the inner workings of a business.

Profitability analysis is useful for business leaders and investors to see which parts of the business generate good margins and which figures hide behind others to obscure any losses. Think of it like a sports team. Sometimes superstar players can make up for poor performers elsewhere. You want to maximize your superstars and cut your underperformers.

An in-depth view of profitability lets business leaders understand what’s driving sales revenue, where efficiency could be improved, and cut costs as needed. 

It’s also handy for predicting future profitability, so companies can decide whether to invest or take on debt without running into financial problems.

Let’s get into some of the common profitability ratios companies use.

Quick tip: Don't forget that you can slice any of the following profitability ratios by cohort to perform customer profitability analysis, which tells you which segments of your customers are most profitable.

Profitability ratio #1: Gross profit margin

Gross profit figures tell us how much profit a business generates from each dollar earned as revenue.

It only factors in the direct cost of sales, like production materials and the labor needed to make products. As for operating costs, interest expenses, and taxes? When it comes to gross profit margins, forget it.

If a company’s direct costs increase, the gross profit margin decreases. The gross profit margin will be higher if the revenue increases and the direct costs decrease.

For good financial health, the aim of the game is to get that percentage up.

Formula

Here’s a basic formula for calculating gross profit margin: 

Gross profit margin = (net sales - cost of goods sold) / net sales

It’s often expressed as a percentage, so you’ll need to multiply the result by 100.

Pros and cons

The gross profit ratio is a great way to look at how profitable sales of a product or service are, as it solely focuses on direct sales costs. 

Taking away extraneous factors like loans, interest, and operations gives insight into how well the company’s products perform. From here, business leaders can recommend whether product lines need to be cut and what the bestsellers are.

On the other hand, it’s difficult to compare overall profitability with companies from other industries as the gross profit margins can look very different. 

It also shouldn’t be used as an isolated figure to report a company’s performance. It only looks at specific sales metrics and ignores others like operations and indirect costs.

Profitability ratio #2: Operating profit margin

Also known as the EBIT profit margin, the operating profit margin looks at how a business does with its operations versus its revenue. It can sometimes be partnered with the operating expense ratio, determining how much revenue is taken up with operating costs.

The ratio only looks at operating costs, which fluctuate over time. Any operating expenses, like admin and product development costs, all contribute to this section. Any interest or tax payments are completely ignored at this point.

Generally speaking, a higher percentage profit margin ratio indicates good financial performance. Keeping operating costs low by making efficiencies relative to the revenue generated means the ratio will be higher.

The ratio will decrease if a company spends more on operating expenses, like investing more funds into L&D, or lowers its prices.

Formula

Let’s look at a basic formula for calculating the operating profit margin:

Operating profit margin = operating profit / total revenue

This will give you the figures to see how a company is doing with its operations versus revenue.

Pros and cons

The operating profit ratio is a good indicator of how a business does over time with its operations. Business owners and investors can spot any potential inefficiencies early on and make changes to improve the ratio.

But the operating profit margin is one small part of the picture. As it doesn’t consider interest and taxes, it can’t be used as a sole financial metric for profitability. For instance, a company could be in the red while maintaining a good operating profit margin.

Profitability ratio #3: Net profit margin

The net income figure is the profit left over after every expense, usually found on the income statement's bottom line. The net profit margin looks at the net profit generated on each dollar of net sales.

It’s an important percentage because the net profit is the ‘pure’ profit after everything else is taken away. More net profit means more room to expand, pay dividends, and grow the company.

An increase or decrease in net profit margin isn’t always straightforward - it depends on more influencing factors than gross profit or operating profit. For a decrease in the margin, the interest and taxes could increase or the operating profit could decrease.

As for a margin increase, the operating profit margin might have gone up or taxes drop as a proportion of the net sales.

Formula

Want to work out your net profit margin? Here’s what you need:

Net profit margin = (net profit / revenue) x 100

This will give you the net profit ratio in a percentage form.

Pros and cons

The benefit of a net profit ratio is that it gives stakeholders a quick snapshot of the company’s financial health. They can quickly determine whether the operating costs and indirect expenses are under control.

However, the net profit margin doesn’t always work as a lone figure. A lower margin doesn’t always mean a company is doing badly, while a high margin doesn’t necessarily equate to a healthy cash flow margin.

It’s important to supplement the ratio analysis with other figures where possible if you’re worried key stakeholders could misinterpret a lower net profit margin and more explanation is needed.

Profitability ratio #4: Return on assets (ROA)

The return on assets (ROA) margin looks at the percentage of net earnings relative to the total revenue generated. Assets can look like PPE, such as machinery, or intellectual property.

Improving the ROA ratio relies on a company increasing its net profit margin. This can be achieved with a new sales strategy to focus on high-margin services or cutting operating costs.

Formula

Here’s what you need to calculate ROA.

Return on assets = (net profit / average total assets) x 100

Note: it can be helpful to take the average of the total assets from the balance sheet. This is because the income statement is a fixed financial document, whereas the balance sheet is continuously updated.

Pros and cons

For investors, the ROA ratio indicates how well a company uses its assets to generate profit. This makes it useful for comparing how it’s doing to other businesses in the industry, as other organizations will have similar assets.

It’s also a useful number to help determine whether a company is being managed well. Stakeholders can make any changes needed to increase profitability if profit is being reinvested into the businesses via assets, and they’re not being used to their fullest potential.

However, you can run into issues with how ROA separates debt and equity capital. Some companies add interest expenses to the equation for a more accurate result.

Profitability ratio #5: Return on equity (ROE)

The return on equity (ROE) margin is how a company’s profitability compares to the shareholders’ investment in the business.

Generally, a higher ROE is a good sign of financial health. Businesses can improve their ROE ratio by raising net profit via sales and volume or reducing equity. The latter is trickier, as it could mean taking on more debt which drives down other profitability ratios.

Some investors prefer to use the long-term S&P 500 average as a benchmark for ROE—anything under that is considered a below-average return. Others compare to the industry itself.

Formula

Let’s look at what calculation you need for ROE.

Return on equity = net profit / shareholders’ equity

Afterward, you’ll arrive at the ROE figure needed to determine the shareholders’ investment relative to revenue.

Pros and cons

ROE is a good way to determine the likely growth of dividends, especially if the ratio is similar to other peers in the sector.

However, it’s not a perfect metric to assess value. You also don’t want a too-high ROE on your hands as it can signify inconsistent profits or too much debt.

Share buybacks can artificially inflate ROE, so the figure should be considered with other financial metrics to determine a company’s true value.

Conclusion: the best profitability ratios for profitability analysis

Profitability analysis is an essential tool in the FP&A toolbox.

And now you know some of the best financial ratios to perform it.

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