Whether you’re a brand-new company trying to break even or you're already making a steady profit, it’s a good idea to spend some time studying your revenue streams. Specifically, you want to identify the most and least profitable aspects, so you can optimize your company’s performance. Profitability analysis breaks down costs, and what they contribute so you can identify which products or customers most contribute to your profits.
In this article, you will learn about profitability analysis and how it can help your business. You will also learn how to do your own profitability analysis in Google Sheets, step by step.
What is a Profitability Analysis?
Profitability analysis is a component of Enterprise Resource Planning (ERP) that allows you to assess the profitability of different aspects of a new or existing project. It can identify the most and least profitable products, services, and clients, so you can optimize your revenue streams and make smarter decisions.
Why Is Profitability Analysis Important?
Profitability analysis provides an in-depth look at a company’s profits from different perspectives by identifying the factors that most contribute to profitability. Profitability analysis can help you monitor performance, optimize your product mix, maximize the use of resources, and evaluate business relationships.
Profitability Analysis Techniques
Multiple methods can be used to perform a profitability analysis, each focusing on different aspects of the company’s performance. However, there are some core methods that are commonly used by most companies.
Perhaps the most basic and fundamental of these methods is break-even analysis, which is used to figure out how much profit you need to make to cover fixed and variable costs. In other words, it helps you determine how much you need to make in sales in order to remain in business. To learn more, read our article on break-even analysis and how to calculate the break-even point.
Another commonly used method is profitability ratio analysis, which relies on a combination of margin and return ratios. Once calculated, these ratios can provide you with insight into your company’s performance by comparing them to industry benchmarks.
A break-even analysis is a financial calculation used to determine a company’s break-even point. Here’s how to calculate the break-even point step-by-step.READ MORE
How to Perform Profitability Analysis?
You can easily perform your own profitability analysis template in Google Sheets or Excel by following the steps below and adding the relevant formulas to your spreadsheet. This will also make it easier to repeat the analysis periodically, which is highly recommended.
1. Gather Data
This is a very important step and requires that absolutely all costs be accounted for, including those that contribute indirectly and are easy to overlook. Missing costs can be misleading, making you think that certain products or customers are more or less profitable than they actually are. In order to make smart decisions, you need accurate data.
2. Break-Even Analysis
This method is commonly used in financial planning, particularly when thinking about investing in a new business or product. Break-even analysis helps you estimate how much you need to sell in order to cover all costs, also known as breaking even. To learn more about it and how you can do your own break-even analysis, check out our article on how to calculate the break-even point.
3. Profitability Ratio Analysis
Profitability ratio analysis focuses on two types of ratios: margin and return. There are many possible ratios that you can use, but you can find some of the most common ones below.
Ideally, you should calculate these ratios separately for different products, customers, etc. The more you can break it down, the more valuable the analysis will be in terms of improving performance and profitability.
Gross Profit Margin
This margin compares gross profit to sales revenue, which shows how much the business is earning, accounting for the cost of producing its goods and services (COGS). A high value suggests that operations are efficient, as it is possible to cover all costs, and the business still has net earnings.
gross profit margin = gross profit / sales
Operating Profit Margin
The operating profit margin expresses earnings before interest and taxes are deducted (EBIT) as a percentage of sales. A high value for this ratio suggests that the business can comfortably pay for its costs and is more likely to survive if the business slows down or prices need to be lowered competitively.
operating profit margin = EBIT / sales
Google Sheets offers plenty of Data Analysis features that we can use to make sense of large data sets. Here’s how to do Data Analysis in Google Sheets.READ MORE
Net Profit Margin
The net profit margin provides an overall picture of how profitable the business is after all expenses have been considered, including taxes and interest. While it does provide a measure of profitability that takes everything into account, this can be a drawback. Since everything is considered, this also includes one-offs: gains or losses that are unlikely to be repeated, which can provide a distorted picture.
net profit margin = net income / sales
Cash Flow Margin
This ratio measures a business's ability to turn sales into cash by showing the relationship between the cash generated in the normal course of operations and sales.
cash flow margin = operating cash flows / sales
Return on Assets
This ratio shows the net earnings relative to the total assets. In other words, it measures a company’s ability to generate profits using its assets: it shows how much profit is made after taxes per dollar owned in assets.
return on assets = net income / total assets
Return on Equity
This ratio shows the net earnings relative to stockholders’ equity. In other words, it shows the rate of return on the money that has been put into the company by equity investors.
return on equity = net income / total shareholder’s equity
4. Add context
Generally speaking, the higher the profitability ratios, the better. However, while these ratios can provide some information on their own, they are much more valuable when compared to industry standards.
You need appropriate benchmarks, so you can compare your findings to those of similar companies. There is little point in comparing your values to those of companies that are bigger or smaller, sell different products, etc. This means you’ll have to do some more research on competitors, but your analysis will become much more valuable.
In addition to tracking competitors, you need to track your own profitability over time. This analysis should be repeated periodically so you can analyze changes in profitability and identify trends. In order to save yourself some time and effort, you can easily set up a template in Sheets or Excel with the necessary formulas and speed up the process.
As you have seen, there are many benefits to doing profitability analysis periodically. By keeping track of your profitability ratios over time, you can gain valuable insights into your company’s profits. Instead of just focusing on the revenue they generate, you can identify the products and customers that generate the most and least profit.
You now know about profitability analysis and the most commonly used methods, as well as the benefits of regularly performing this type of analysis. You also know how to set up the formulas in Google Sheets, so you can focus on analyzing the results.