#018 How to assess the profitability of your business

A few years ago, our accounting professor asked students in the MBA class, “Which is better?” Make $1 million in sales with a profit of $100,000, or make $500,000 in sales with a profit of $118,000? The answer to this question is not obvious. One thing is certain, it is necessary to ask yourself how much effort and resources my company used to generate a profit of 10% ($100K) in the first case and a profit of 23.6% ( $118K) in the latter case.

Let's start by defining it: profitability refers to the company's ability to control its costs and generate profits.

As a manager and owner of our business, we must also ask ourselves the following question: has it been a good year? From our financial statements, we can calculate some ratios that will allow us to put everything into perspective and make better business decisions. To get started, here are some definitions.

Gross profit

• Gross profit is the difference between net turnover (CA) and cost of sales (CV). We exclude, from our calculation, selling and administrative expenses (FVA), as well as financial charges (CFIN).
• Gross profit allows us to evaluate the performance of our sales, our purchasing policies, and our inventory management. Turnover = Turnover less returns and discounts on sales.

Operating profit

• Operating profit is the excess of the company's turnover over its expenses. It is important to adjust the operating profit for all sales not arising from your normal activities, that is, extraordinary expenses and sales (for example, purchase of investments, sale of assets , capital gains or losses), income taxes, dividends, performance bonuses and withdrawals by owners.

Net profit

• Net profit (BN) is the difference between turnover and total expenses (CV + FVA + CFIN) during a financial year.
• The BN takes into account depreciation, charges and taxes, and all extraordinary elements or those not arising from your normal activities.

How to calculate everything?

Now, let's look at the example of the two companies: A ($1M turnover) and B ($500K turnover).

Calculation of financial ratios

Analysis by financial ratios

Financial ratios allow us to better understand and analyze the evolution of our company and also to compare ourselves to other companies in the same sector. The ratios we present in this blog are for informational purposes only. It is also necessary to analyze the financial structure, activities, financing and liquidity ratios. These ratios will be presented in the coming months.

Let's return to our companies A and B and see how to calculate 3 standard ratios (net profit margin, variable cost margin rate, return on shareholders' investment).

The net profit margin ratio

• The net profit margin ratio presents the overall profitability of the company, which is the % of net sales that a company generates after covering its total costs. The higher this ratio, the better the profitability of the company.
• Net profit (BN) / CA

Contribution margin and contribution margin rate

• The contribution margin (MCV) makes it possible to determine whether the company achieves a sufficient sales volume to cover its fixed costs, therefore make a net profit, or even reach its break-even point in certain cases.
• Net sales (CA) minus cost of sales (CV) = contribution margin (MCV)
• Margin rate on variable costs = MCV / CA

The return on shareholders' equity ratio

The return on shareholder equity ratio measures how much each dollar invested earns. The greater this ratio, the better the profitability, and the attraction of a banker or financier is all the more interesting.

Ratio analysis

Summary analysis of the net profit margin ratio

• The net profit margin ratio indicates that Company B has a better net margin than Company A. An in-depth analysis of selling and administrative expenses might reveal high expenses for certain expense categories. For example, in order to generate 2X more sales, sales costs (salaries, commission, advertising and marketing) could be higher. Year in, year out, in both cases, it is necessary to ensure that fixed costs are well managed and well controlled in order to achieve better net profitability.

Summary analysis of the margin rate on variable costs

• Company B sold fewer units (4,000) relative to Company A (10,000). On the other hand, the selling price is $125 for company B versus $100 per unit for the first. Is Company A's pricing strategy too aggressive to the detriment of its profitability? Are there replacement or warranty costs? For example, increasing the price by $10 per unit would generate an additional profit of $100,000.

Return on shareholder equity ratio

• The return on shareholder equity ratio measures how much each dollar invested returns to shareholders. Analyzing our financial results allows us to better understand the profitability of the business we operate. Company B being more profitable than company A, so B can either reinvest in its brand, its R&D, its training, etc.

Here are some tips and tricks to improve your profitability

A company that wants to improve its net profit (its profitability) can do so in several ways, here are some of them:

• Think about net margin rather than revenue. If you do not make a profit, you will neglect paying your suppliers, you will be less attractive to a banker and you may jeopardize the short-term profitability of your business.
• Focus on quality, after-sales service, added value and increase your prices in order to increase your turnover while keeping your costs at the same level.
• Reduce your operating costs and consider outsourcing where you can. Entrust the management of certain low-value-added tasks to specialists.
• Make your staff a source of profitability . Tired, stressed or unmotivated staff are much less productive, so do not neglect your human resources, especially as we are going through a very difficult recruitment period, in almost all industries.

About the Author

Christiane Constantineau has a DESS in corporate finance as well as an MBA for executives. She has more than 30 years of experience in financial strategy, both in Canada and abroad, and has participated in the financing and start-ups of several companies.