What is Profitability Analysis? Definition and Importance

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Pratibha Devasenapathy | Nov-13-2020

What is profitability analysis?

When a company is incepted, one of the sole purposes of it is to make profits. Basically, to earn more than you spend is what every business owner wants for his company. Thus, to assess the growth of your business, careful study on profit is important, and that is pretty obvious. However, the nuances that secretly lie under various financial statements, will give you the real picture of your company’s profits.

Analysing of the profits which is basically the money remaining from the capital after subtracting all the overhead costs, will help you keep a track of your business’ performance. Profitability analysis allows companies to maximise their profit. Thus, resulting in maximising the opportunities that business can take advantage of, in order to continue growing in an extremely dynamic, competitive, and vibrant market. Profitability analysis helps businesses identify growth opportunities, fast/slow-moving stock items, market trends, etc, ultimately helping decision-makers see a more concrete picture of the company as a whole.

Importance of profitability analysis

While profitability analysis gives business owners a 360° view of your company’s profits, different ratios that derive profitability ratios have different roles to play. Let’s take a look at the importance of these ratios:

  • Gross profit margin

It is a measure of the profit earned on sales which denotes the profit part of the total revenue earned, after deducting the costs of goods sold (COGS). This report is extremely important as it covers the admin and office costs and also includes the dividends which are to be distributed to respective shareholders of the company. Higher the gross profit, the company will be more profitable. Gross profit margin is also used to assess the efficiency of cost management. So, if the ratio is low, the business owner can then identify these pain points and improve purchasing and production in terms of economy and effectiveness.

  • Net profit margin

It is the final ratio that validates the overall performance of a company. Any disturbances in other ratios will impact the net profit margin ultimately, thus this report is considered as one of the most important ratios. A low quick ratio would mean that sales have been low in a particular period, eventually impacting the net profit margin. This analysis will help investors to identify the cracks in the way they operate and take timely decisions to improve the company’s performance.

  • Returns on equity

Returns on equity is the percentage of the earnings, which shareholders get in return for the investments made towards the company. Higher the ROE, higher will be the dividends shareholders will receive. This triggers more investors for your company ultimately aiding in keeping your company afloat in the market.

  • Returns on capital employed (ROCE) and Return on assets (ROA)

These returns measure the efficiency of a company in utilising of its assets. By evaluating ROCE, the management can take decisions that’ll help them minimise the inefficiencies. Higher the ROCE, higher will be the efficiency in the production process of the company.

ROA is a measure of every penny of income earned on every penny of the asset owned by the company. Similar to ROCE, ROA also helps the management manage the utilisation of assets, diligently.

Profitability ratio analysis

Analysts and investors use profitability ratios to measure and evaluate a company’s ability to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders’ equity during a specific period of time. They show how well a company utilises its assets to produce profit and value to shareholders.

A higher ratio establishes that the company is on the profitable side and is generating enough revenue, profit and cash flow. This ratio analysis comes in handy while doing a comparative analysis with your competitors in the market or even with previous periods, to understand the current financial position of your firm.

 Profitability ratio analysis

Let’s dive deeper into understanding what these categorisations mean:

  • Margin Ratios

To understand your company’s financial status during a specific period, it is imperative to understand your company’s ability to convert sales into profits. That is what margin ratio represents at various degrees of measurement. Some of the examples are gross profit margin, operating profit margin, net profit margin, cash flow margin, EBIT, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), NOPAT (Net Operating Profit After Tax), operating expense ratio, and overhead ratio.

  • Return Ratios

As the name suggests, return ratio us nothing but the company’s ability to generate returns to its shareholders. Examples include return on assets, return on equity, cash return on assets, return on debt, return on retained earnings, return on revenue, risk-adjusted return, return on invested capital, and return on capital employed.

How TallyPrime helps in simplified analysis of profit ratios

With easy navigation of reports in TallyPrime, you can get a holistic view as well as you can dive deeper to find out the minutest details of the profits earned. The ratio analysis report is primarily divided into two parts, principal groups and principal ratios. The principal groups are the key figures that give perspective to the ratios. Principal ratios relate two pieces of financial data to obtain a comparison that is meaningful. You can simply select 'Ratio Analysis' on Gateway of Tally and you can see your financial statements at a single shot for the selected period. From gross profit percentage to knowing your returns on investments, every single detail is easily accessible with the ratio analysis report.

Profit ratio analysis

You can even drill down to each of the ratios to understand their derivations and take decisions that will help improve your business efficiency. 

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