Profitability is the ability of a company or business to generate revenue over an above its expenses and is usually measured using ratios like gross profit margin, net profit margin EBITDA, etc. These ratios help analysts, shareholders, and stakeholders to analyze and measure the company’s ability to generate revenue to cover its operational cost, create value by adding assets to balance sheet and analyze its ability to expand and take up projects for its future growth.
- Higher the ratio, the better it is as it means the company is performing well.
- These ratios are often used to compare the performance of companies against each other.
- Profitability is not only used by business owners, but also by investment analysts to determine whether it’s wise to invest or not considering it current and future growth.
How to Analyze Profitability?
Let’s take an example of profitability.
- Sales = $50,000
- Purchase = $30,000
- Direct Costs = $500
- Rent = $1,000
- Salary = $3,000
- General Expenses = $1,500
- Depreciation = $500
- Interest Paid = $200
- Taxes @ 30% = 3,990
Profit = $ (50,000-30,000-500-1,000-3,000-1,500-500-200-3,990)
Profit = $9,310
Let us calculate most commonly used ratios to determine profitability
#1 – Gross Profit Margin
Gross Profit Margin is a ratio of gross profit to sales, which means if the entity is able to recover its cost of production from the revenue it’s earning. Higher the ratio, the better it is.
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As per the above example:
Calculation of Gross Profit will be –
Gross Profit = $(50,000-30,000-500)
Gross Profit = $19,500
Calculation of Gross Profit Margin will be –
Gross Profit Margin = 19,500/50,000
Gross Profit Margin = 39%
#2 – Net Profit Margin
Net Profit Margin a ratio of net profit to sales. Net profit is the profit earned after reducing operational costs, depreciation and dividend from gross profit. Higher ratio/margin means the company is earning well enough to not only cover all its cost but all payout to its shareholder or re-invest its profit for growth.
Profitability = $9,310 / 50,000
Profitability = 18.62%
As calculated above, the net profit margin is 18.62%.
#3 – Operation Profit Margin
Operating Profit Margin a percentage of earnings to sales before interest expense and income taxes. Higher margin means companies are well equipped to pay for its fixed and operational costs. It also indicates efficient management and their ability to survive in economic downtime compared to their competitors.
As per the above example:
Calculation of Operating Profit will be –
Operating Profit = $(50,000-30,000-500-1,000-3,000-1,500-500)
Operating Profit = $13,500
Calculation of Operating Profit Margin will be –
Operating Profit Margin = 13,500/50,000
Operating Profit Margin =27%
#4 – EBITDA
Its earnings before interest, tax, depreciation, and amortization. EBITDA is commonly used to compare a companies performance with others and is widely used in valuation and project financing.
As per the above example:
Calculation of EBITDA will be –
EBITDA = $ (50,000-30,000-500-1,000-3,000-1,500)
EBITDA = $14,000
Some of the advantages are as follows:
- Profitability helps us in determining the pricing of our product and services and in many cases if any revision is required. Pricing is very important for any business, as it not only leads to increases in net revenue but it also has to be at a close level with competitors. Profitability helps in pricing strategy.
- Higher profitability is directly related to higher sales. The various ratios and metrics which are used help in comparing past data and analyze if the company can survive in a downtime.
- Profitability helps us in analyzing the return of investment from a business. This means how effectively the company issuing its resources to generate value and profit. Profitability lets us know if the resources are properly deployed and if it can sustain in the future.
Some of the disadvantages are as follows:
- Does not predict company performance in the future accurately as companies often window dress their financial statements.
- Cannot compare companies performance across different industries. For example, the analysis of comparing pharmaceutical with FMCG industry wouldn’t be accurate.
Profitability ratios are key indicators to analyze the performance and liquidity of the company and are derived using income statements. It is also used to determine the strengths and weakness of a business and also how companies achieve profit from their operations. Analyst use ratios to determine whether it’s a good proposal for investment purpose and banking institutions use such ratios to often determine the creditworthiness of a company and sanction loans based on such ratios. Amongst other ratios, profitability ratios are of utmost importance as all businesses ultimately focus on earning profit and creating value for its stakeholders.
This has been a guide to what is profitability and its meaning. Here we discuss the formula to calculate profitability ratios along with examples, advantages, and disadvantages. You can learn more about valuation from the following articles –