February 1, 2024
Profitability analysis is an essential tool for businesses to evaluate their ability to generate a profit, providing insights into how various revenue streams and costs affect financial performance.
With the right financial analysis software, profitability analysis helps you pinpoint the specific business units, products, customers or assets contributing most to profit, and those that are underperforming.
It allows you to identify trends over time, operational inefficiencies and opportunities for growth, as well as showcasing the top 10 accounts contributing to revenue.
In this guide, we take a deep dive into all the essential elements of profitability analysis, its benefits and the most common techniques involved. We also share solutions to common challenges and provide a profitability analysis example to give you an idea of what’s involved.
Profitability analysis is the process of examining a business’s revenue streams and costs to evaluate its ability to generate profit. It helps you spot opportunities for increasing your bottom line by breaking down the profitability of specific products, geographic locations, business units, initiatives and distribution channels, amongst other factors.
This form of analysis involves using profitability ratios and qualitative data to identify strengths and weaknesses in a business’s revenue generation and cost structures. Such insights can help you prioritise initiatives that enhance profitability, allocate resources effectively and drive sustainable growth.
If you’d like to read more about the fundamentals of financial data analysis, then check out our article on this subject.
Profitability analysis is crucial as it allows you to:
There are myriad ways to perform profitability analysis, which typically involves using a variety of ratios as well as qualitative data. Here we explore the most common elements of a profitability analysis for small to medium-sized businesses:
A break-even analysis allows you to determine the point at which your business will be profitable. Specifically, it identifies the point at which revenue generated from sales covers fixed costs (such as rent, salaries and utilities) and variable costs (like materials and labour), resulting in neither a profit nor loss.
Performing this analysis allows you to understand the minimum level of sales necessary to cover all expenses and begin generating profit. A break-even analysis can also be applied to specific customers to find out how many units must be sold to a customer to break even.
There are a variety of profitability ratios that allow you to analyse profit. These ratios are financial metrics that provide insight into your business’s ability to generate profit relative to factors including its revenue, operating costs, invested capital and assets.
The two types of profitability ratios generally used for profitability analysis are margin ratios and return ratios. Margin ratios assess a business’s ability to generate profit via sales, while return ratios analyse the returns a business can deliver to shareholders.
Another important area of your business to analyse is the profits specific customers generate. A customer profitability analysis allows you to determine the profit brought in by a customer against the cost of selling to them. It provides insight into which customers are generating the most or least profit, so you know which to focus your attention on.
Many businesses incorporate qualitative data into their profitability analysis from customer surveys, focus groups, SWOT analyses or market research. This data can provide contextual insights into customer preferences and market trends that may influence profitability.
Performing a profitability analysis involves using a variety of margin and return ratios. These allow you to examine profitability relative to different costs or assess the profitability of your assets and investments.
In general, the higher the ratio, the better your business’s profitability. Some of the most widely used ratios include:
This metric reveals the profit earned from sales after deducting cost of goods sold (COGS), which includes direct production costs as well as administrative and office expenses. Gross profit margin provides COGS as a percentage of sales, allowing you to identify areas for improvement in purchasing and production processes to enhance overall profitability.
(Total revenue - COGS) / (Total revenue)) x 100 = Gross profit margin
While gross profit margin shows you how much total revenue is left over after deducting COGS, the net profit margin provides a more complete picture. It considers all expenses, including taxes, interest and operational costs, to determine the percentage of net income against sales. This ratio provides the percentage of revenue retained as profit, allowing you to see your business’s overall ability to generate a profit.
(Net income / Sales revenue) x 100 = Net profit margin
This ratio provides insight into how efficient your business’s operations are. It shows you the percentage of sales you retain after paying operational expenses, but before paying interest and taxes. A high operating profit margin means your operations are turning a healthy profit and that there’s sufficient cash left over to pay for other expenses.
(Operating profit / Total sales) x 100 = Operating profit margin
ROA allows you to gauge the efficiency with which your business is utilising its assets to generate returns, providing visibility of the money generated for every dollar of assets owned. This metric can be applied to your total assets or individual assets, like a piece of equipment, for example.
(Net income / Total assets) x 100 = ROA
Cash flow margin calculates how much income, or cash, a business generates from its operating activities relative to its net sales. It reflects the efficiency of converting sales into cash and provides insights into your company’s liquidity.
(Net cash from operating activities / Net sales) x 100 = Cash Flow Margin
ROE represents the percentage of earnings shareholders receive in return for their investment in your business. It allows you to see how well your business is managing the capital invested by the shareholders, and the amount of value generated from it.
(Net Income / Shareholders' Equity) = ROE
ROI evaluates the profitability of investments by comparing the gain or loss generated relative to the initial investment cost. It helps you assess the effectiveness of your investment decisions and allocate resources efficiently to achieve optimal returns.
(Net Return / Cost of Investment) = ROI
Here, we explore the main benefits that profitability analysis can provide your business. It can help you:
Because profitability analysis helps you understand how different parts of your business contribute to profit, you can then target those areas with the most growth potential.
For instance, an analysis may reveal certain products are more profitable than others. You can then allocate more marketing and sales resources to these products to maximise profits. You may even decide to rationalise your products to drop those that are less profitable and focus all your efforts on those generating the most returns.
By examining profitability trends over time, a historical financial performance record is established and maintained. This record can be used in ongoing assessments of future profitability metrics and facilitates forecasting and strategic planning.
With a profitability analysis you’ll be able to gain a better understand of how effectively you are leveraging your business’s assets to generate revenue and profit.
Once the analysis is complete your business can gauge how to use its assets more smartly, and strike a balance between reliability and efficiency in asset maintenance moving forward.
Profitability analysis helps you identify which of your products or services will generate the highest profits, as well as which ones are the least cost-efficient.
For many businesses, some accounts are simply more profitable and less costly. Analysing the profitability of yours will help you understand which top 10 revenue and expense accounts are contributing the most to your bottom line.
Incorporating cost accounting methods into your profitability analysis allows you to hone in on the processes and activities that are inefficient and driving up costs. This includes:
So, now that you have an idea of the key components of profitability analysis, and the various ratios involved, how do you get started? Here we break it down into four key steps:
Profitability analysis begins by collecting a range of financial data from your financial reports, profit and loss statement, balance sheet, income statement and statement of cashflows.
To benchmark your business against competitors, you'll need to research how you can access your competitor balance sheets.
The first step when analysing financial performance is to perform a break-even analysis. This allows you to see how much your business needs to sell to cover its fixed and variable costs. You can perform a break-even analysis for your business as a whole, or for individual products and customers.
You can also test break-even points for different scenarios. For instance, you can test scenarios where the price of a product is lower or variable costs are higher, allowing you to see at which point your business no longer breaks even.
Use the ratios we shared above to calculate margin and return ratios for both your current and prior periods, allowing you to see if profitability is increasing or decreasing over time. This may reveal trends like, for instance, higher volumes of orders but decreasing profitability.
You can gain more granular insights by calculating ratios for specific customers or products. For example, you may realise that while some customers generate high revenue, this may be offset by the high costs involved.
The final step in your profitability analysis should be to compare the results of your break-even and ratio analyses against industry benchmarks and competitors. This helps you gain more understanding of how your business is performing.
For instance, your operating profit margin may seem low in absolute terms, but when compared to the industry average or that of a competitor, you might be performing relatively well.
Let’s look at a profitability analysis example to see how you can gain insights into your business’s costs. In this example, Company ABC will use the activity-based costing method to determine the cost driver rate of producing Product A.
The company has 10 machines set up that incur $15,000 in overhead costs. Five of these machines have been set up to produce 100 units of Product A each day.
Given there are 10 machines set up and $15,000 in overhead costs, we can first calculate the overhead cost per machine setup:
Overhead cost per machine setup = Total overhead costs / Number of machine setups = $15,000 / 10 = $1,500 per machine setup
Since there are five machines set up to produce 100 units of Product A each day, we can calculate the overhead costs allocated to Product A as follows:
Overhead costs for Product A = Overhead cost per machine setup X Number of machine setups for Product A = $1,500 X 5 = $7,500
Therefore, the overhead costs for producing 100 units of Product A each day using the activity-based costing method amount to $7,500.
Let’s look at the main challenges many businesses face when performing a profitability analysis and how they can be solved:
Quality data is essential for an accurate profitability analysis, particularly for businesses with diverse data sources and systems. Many businesses, however, face the challenge of consolidating data that’s dispersed across disparate systems or business units. Some data may also be inaccurate or incomplete due to poor data entry and hygiene practices.
Data integration tools and systems can help collect and consolidate data from multiple sources, while robust data governance practices and regular data quality audits can help improve data quality.
Resource constraints and a lack of skilled personnel can impede profitability analysis efforts. Small businesses in particular may struggle to find time to gather all the necessary data and perform the calculations needed, which is often a time-consuming process.
Overcoming this challenge requires prioritising profitability analysis as a strategic initiative and allocating sufficient resources to it. Automation of data gathering processes and investment in cash flow analysis tools can help you simplify and speed the process.
The complexity of profitability analysis techniques can be challenging for those that don’t have a financial background. To overcome this, you may want to invest in training and development programs to help your staff build financial skills.
You could also seek support from financial experts or invest in software with profitability analysis capabilities, allowing you to save significant time and effort.
By now, you should have a fair understanding of the key elements of a profitability analysis and the kinds of insights it can provide.
A profitability analysis is indispensable for businesses. It helps you understand which areas of your business are driving profit, those that aren’t, and spot opportunities to cut costs and improve operations.
Given the complexity of some of the work involved, the process is however challenging for many businesses who don't have the time or financial skills required to analyse financial data.
Trusted by over 80,000 organisations worldwide, Fathom provides specific features designed to simplify profitability analysis.
Its profitability tool allows you to evaluate your business’s ability to generate profits and manage fixed and variable costs, providing visualisations to help you make sense of your numbers.
Fathom also makes it easy to create and monitor key profitability KPIs, and integration with accounting platforms like Xero and QuickBooks means you can avoid the hassle of manually transferring financial data.
See for yourself how Fathom makes profitability analysis simple with a free 14-day trial that’s completely credit-card-free.
Fathom is a cloud-based financial intelligence and management reporting app trusted by more than 50,000 companies worldwide.
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