How To Measure Profitability in Your Business Like a Pro Investor
If your P&L statements are a net positive, it means that your company is turning a profit. But, it doesn’t mean that it’s profitable.
Confused? While turning a profit is usually when the point that a business is considered successful, profitability is a measure of the financial efficiency of your organization. It gets a little more complicated from there, so allow me to explain…
Understanding Profitability
Let’s imagine two kids, Alice and Bob, who each run a lemonade stand for a day.
Alice spends $10 on supplies. She sells 50 cups of lemonade at $1 each, earning $50 in revenue. Her profit is $40 ($50 revenue - $10 expenses).
Meanwhile, Bob also spends $10 on supplies. He sells 20 cups of lemonade at $2 each, earning $40 in revenue. His profit is $30 ($40 - $10).
Although Alice has a higher profit margin than Bob, Bob’s lemonade stand actually turned out to be more profitable.
Why?
Because, unlike Alice, Bob was able to generate more profit per dollar of revenue. Bob was able to utilize his resources more efficiently than Alice, which will enable him to expand his profits as he scales up to a multinational lemonade stand chain.
Profit vs Profitability: What’s the Difference?
Profit is an absolute number that represents the amount of money a company earns after subtracting all expenses from revenue. It is the bottom-line net income figure found on the income statement or balance sheet.
Profitability — usually expressed as a ratio or percentage — is a calculation that’s used to assess how efficiently your company is generating its profits. It’s a relative measure taken against metrics like revenue, assets, or equity. Unlike profit, it’s all about strategic decisions, helping to guide the long-term growth of a company.
Things Commonly Confused With Profitability
Profitability is often confused with other financial metrics like revenue, cash flow, and growth. Here's a brief overview of how it differs from these other concepts:
- Revenue: Revenue is the total amount of money a company earns from its business activities (usually, selling goods or services). While revenue is crucial, it doesn't account for expenses. A company can have high revenue but still be unprofitable if its costs exceed its income.
- Cash Flow: Cash flow measures the amount of cash moving in and out of a business. It's possible for a profitable company to experience cash flow problems if it has trouble collecting payments from customers, or has high upfront costs. Conversely, a company can have positive cash flow but low profitability if it's not generating sufficient income relative to its expenses.
- Growth: Growth refers to an increase in a company's revenue, market share, or other key metrics over time. While growth is often a positive sign, it doesn't necessarily translate to profitability. A company might be growing rapidly but still losing money if its expenses are growing faster than revenue.
- Market Share: Market share is the percent of total sales in an industry generated by a particular company. A company could have a large market share but low profitability if it's operating in a highly competitive, low-margin industry.
- Valuation: Valuation determines the current worth of an asset or company. While profitability is a key factor influencing valuation, other factors like growth potential, market conditions, and intangible assets also play a role. A company with low current profitability could still have a high valuation if investors believe in its future potential.
6 Ways to Measure Profitability
Since profitability is not an absolute number, there are multiple ways to measure if a company is running profitably. These include looking at different margin ratios, calculating the return on assets, or conducting a break-even analysis.
1. Gross Profit Margin Ratio
Gross profit margin ratio measures the profitability of a company's products or services. It is calculated by dividing gross profit (revenue minus cost of goods sold) by total revenue and multiplying by 100.
(Gross Profit ÷ Revenue) × 100
This ratio indicates the percentage of each dollar of revenue that the company retains as gross profit after accounting for the direct costs of producing the goods or services (COGS).
2. Operating Profit Margin Ratio
Operating profit margin ratio measures a company's profitability from its core business operations, excluding interest and taxes. It is calculated by dividing operating income by revenue and multiplying by 100.
(Operating Income ÷ Revenue) × 100
A higher operating profit margin indicates that a company is more efficient at managing its operating costs, such as salaries, rent, and utilities.
3. Net Profit Margin Ratio
Net profit margin ratio measures a company's overall profitability. It is calculated by dividing net income (profit after all business expenses and taxes) by revenue.
(Net Income ÷ Revenue) × 100
This ratio reveals the percentage of each dollar of revenue that remains as net income after accounting for all expenses, including interest and taxes.
4. Return on Assets (ROA)
Return on assets (ROA) measures how efficiently a company generates profit from its assets. It’s calculated by dividing net income by total assets.
Net Income ÷ Total Assets
ROA gives investors a clear idea of how effective the company is in converting investment capital into net income. This is one of the key metrics that banks look into before financing a business operation.
5. Break-Even Analysis
Break-even analysis determines the point at which a company's revenues equal its total expenses (measured in absolute number of units). At the break-even point, the company is not making a profit or a loss.
Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit)
Break-even analysis helps small businesses determine how many units they need to sell or how much revenue they need to generate to cover all their expenses. This information is crucial for setting sales targets and pricing strategies.
6. Profitability Index (PI)
Profitability index (PI) measures the profitability of a proposed investment or project, by dividing the present value of future cash flows by the initial investment.
(Present Value of Future Cash Flows) ÷ (Initial Investment)
If the PI is greater than 1, the project is expected to be profitable. If the PI is less than 1, the project is expected to be unprofitable. PI helps small businesses evaluate the potential profitability of different investments or projects, allowing them to prioritize those that are expected to generate the highest returns.
Mistakes To Avoid When Measuring Profitability
If you’re in the 98% of the businesses that turnover less than $10m of annual revenue, chances are your ‘accounting profit’ is misleading.
He’s not wrong. When it comes to measuring profitability, small businesses are the most likely to be miscalculating their accounts. But there’s a lot of nuance that goes into this, so mistakes are understandable.
What’s important is that you address these mistakes before they lead you into more serious operational issues; here are 5 of the most common mistakes I’ve noticed companies make when calculating profitability:.
1. Ignoring Non-Operating Income and Expenses
Non-operating items like interest income, dividend income, gains or losses from investments, and one-time events can distort the true financial performance of the business. If you don’t separate these from operating expenses when measuring profitability, you may end up with an inaccurate ratio.
For example, if a company sells a piece of real estate for a large gain, it will boost net income for that period. However, this gain is not related to the company's core operations and is non-recurring. Including it in profitability calculations like net profit margin would exaggerate the company's actual operational profitability.
2. Failing to Consider Asset Turnover
Focusing solely on margin ratios like gross profit margin, you may end up ignoring asset turnover and asset utilization.
For instance, Company A and Company B both have a net profit margin of 10%. However, Company A has an asset turnover ratio of 1, while Company B has an asset turnover ratio of 2. This means that Company B is generating twice as much revenue per dollar of assets compared to Company A.
Despite equal margins, Company B is more efficient at using its assets to generate sales and thus, more profitable overall.
3. Not Adjusting for Inventory Valuation Method
Inventory valuation methods (FIFO, LIFO, weighted average) can significantly impact reported profitability. During periods of inflation, LIFO will result in a higher cost of goods sold and lower reported profits, compared to FIFO.
Comparing the profitability of two companies using different inventory methods can lead to flawed conclusions. Investors typically adjust financial statements to use the same inventory valuation method for an apples-to-apples comparison, so be sure to take this into consideration when comparing your own company.
4. Comparing Profitability Across Different Industries
Each industry has different characteristics that affect typical profitability levels. For example, grocery stores have low margins and high volume, while software companies have high margins and lower asset turnover.
Comparing the profitability ratios of a grocery chain to a software company wouldn’t provide meaningful insights. Profitability should be compared within the same industry, or to the company's own historical performance.
5. Relying on a Single Profitability Ratio
Each profitability ratio provides a different perspective; relying on just one can give an incomplete picture. For example, a company may have a high gross profit margin but a low net profit margin due to high operating expenses.
A comprehensive profitability analysis should consider multiple ratios — both margin and return related — to get a holistic view.
- Margin ratios like gross profit margin and net profit margin show the profitability at different levels of the income statement.
- Return ratios like return on assets and return on equity show how effectively the company is using its resources to generate profits.
Using Software to Measure Profitability
If you’re a small business looking for a faster and more reliable way of measuring profitability, accounting software can greatly streamline the process by automating many of the data entry and calculation tasks.
Most of these platforms integrate with a company's bank accounts, credit cards, and other financial data sources to automatically import and categorize transactions. They can then generate profitability reports, such as income statements and cash flow statements, with the click of a button. Some other basic features that help with profitability measurement include:
- Automatic transaction categorization
- Customizable financial reports
- Real-time dashboards with key profitability metrics
- Integrations with payment processors and invoicing tools
- Budgeting and forecasting tools
For example, QuickBooks Online offers a "Profit and Loss" report that shows a company's income, expenses, and net profit over a selected period; Xero has a "Business Performance Dashboard" that displays real-time profitability metrics like gross profit margin and net profit margin; FreshBooks allows users to create and send invoices, track time and expenses, and generate profitability reports for individual clients or projects.
With the real-time insights and customizable reports that allow you to slice and dice your accounting data from multiple perspectives, you can get a much better understanding of your company’s overall performance and profitability.
The Best Accounting Software Options
Our team has taken a critical look at the accounting software options on the market, to figure out which is best. Here’s our updated list showing who’s in the lead:
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So, to summarize:
Profitability is a nuanced concept. There’s more than one way to measure it, with plenty of scope for making mistakes along the way. If you feel tired of using Excel sheets to keep track of it all, consider investing in good accounting software to automate the process.
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