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What is Profitability Analysis?

It is defined as the type of analysis which is an integral part of an Enterprise Resource Planning (ERP) system and this type of analysis is much significant for the business leaders to optimize the net profitability of a business. Plans, projects and products are systematically analysed using various revenue streams of the business. Previous departmental performance against the Key Performance Indicators is one of the major contributions of profitability analysis. This type of analysis is mostly conduct by investors so that they can determine the ability of a company to generate revenue. The analysis is also much helpful for the investors as it allows them to understand the contribution of a company. This financial metrices can help in understanding the gross profit, operational profit of the business. Forecasting the net profitability of the business is also one of the key contributions of profitability analysis for the trade and business analysts. There are numerous concepts which are associated to profitability analysis such as return on equity, earnings per share, return of the capital which is invested in the business, return of the assets, gross profit.

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What are the two types of profitability?

There are two different categories of profitability analysis such as account based profitability analysis and cost based profitability analysis. Cost based profitability analysis (CBPA) makes the most out of various value fields to calculate the profitability of a business such as discounts, material costs, and revenues. This type of profitability analysis is mostly used by trade analysts all over the world. However, there are few limitations which are associated to CBPA as well such as its compatibility issues with financial accounting. The differences in the value flow to financial accounting and value flow to profitability analysis is also one of the drawbacks of this type of profitability analysis. This type of mismatch can lead to severe business loss for trade analysts as a result this type of analysis is a bit vulnerable as compared to account based profitability analysis. This type of profitability analysis is much helpful for the trade analysts as it is linked to financial accounting. Prior to the introduction of S/4HANA, account based profitability analysis was mostly used in the business organizations. This type of analysis can help in the creation of profit and loss statement as well. The method of calculating the net profitability of a business is much simpler to calculate in a cost based approach as compared to account based approach.

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How do you calculate profitability analysis?

In order to determine the profitability of a business, it is much significant to identify different categories of profitability ratios such as earnings per share of the business, return on capital employed, return of the assets of the firm, calculating gross profit and net profit of the firm. Each of these profitability ratios needs to be calculated in the first place for determining the profitability of a business. Hence, it can be comprehended that both margin ratios and return ratios are much significant for calculating profitability of the business. Financial modeling such as calculating the net present value of the business can also help in predicting the profitability of the business in the coming years. Break even analysis is another way of calculating the profitability of a business. The calculations required for profitability analysis is illustrated in the following pictorial illustration.

Figure 1: Calculating profitability of a business

What is the difference between profitability and profit?

Profit is defined as the amount of money which is left after paying each and every expense associated to the business. Whereas, the degree to which a business or activity which yields profit and financial margin can be defined as profitability. Income statement can be used by trade analyst for identifying the profit of the business. On the other hand, the overall success of the business can be determined only from the net profitability of the business rather than profit. Net profitability is much significant in comprehending the economic health of a business which is not possible by studying profitability. Entire sustainability of a business can be determined in the first place using profitability as well. Calculation of profit and profitability is also very much different from each other, it can be said that profit can be calculated from the net revenue of the business on the other hand, net profitability can be calculated from different categories of profit margins such as operational profit, net profit, and gross profit. Hence, it can be comprehended that the state of yielding profit or financial gain can be determined in the first place using profitability. On the other hand, profit can be described as the financial benefit when revenue generated from business activity exceeds cost, tax and expenses. Hence, it can be understood that profit and profitability are very much different from each other.

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Why do we do profitability analysis?

Conduction of profitability analysis is much helpful for the global as well as the smaller organizations to maximize their profit margins. It can also help business organizations to identify the different areas of opportunities. Movement of the stock items can be managed in an optimised modus with the conduction of profitability analysis. Market trends can also be understood in the first place with the conduction of profitability analysis. Profitability analysis is much significant for the decision makers of a business to make all the decisions which can help them in having a competitive edge. Satisfaction of customers can also be tracked and managed in the first place due to the conduction of profitability analysis. Location of the business along with the necessity to make further amendments can be identified using profitability analysis as well. Security and transparency of the financial transactions which are associated to the net profitability of a business can also be enhanced in the first place with the conduction of profitability analysis. This financial metrices is much useful for attracting new investors for the business as well. Thus, it can be understood that profitability is much helpful for business organizations to grow their businesses and address issues like business failures.