Profitability is in and of itself, a fairly simple concept. In order for a company to thrive in business, it must make a profit. It must incur income to maintain operations, grow and expand. A company who fails to bring in profit cannot stay in operation. It will last as long as the cash on hand lasts. In effect, this is poor business planning.
Even though this is a basic principle, analyzing profitability is more complicated. It is usually analyzed in two phases. Profitability can be measured in terms of its relation to sales and its relation to investment.
Profitability in Relation to Sales
In this equation, profit (or income) equals a company’s sales minus its expenses. It is necessary to account for cost of goods sold, salaries, rent, utilities, depreciation, interest and taxes on income when considering expenses. Looking at income statements for consecutive years may demonstrate a hearty increase in sales yet this substantial increase may not be reflected in the profits.
To gain a better perspective of the cause, look at income statements known as Common-Size Income Statments. This type of statement converts the figures to percentages. Doing so will assist in your analysis.
Normally, in the case when sales increase yet profit remains stagnate, a disporportionate increase in the total expenses is the cause. Further analysis of these particular expense categories will help to correct the profit sluggishness.
Profitability in Relation to Investment
Capital must be invested in assets like equipment, inventory, and research. Determine the basic earning power of the business by calculating the return on total assets (ROTA). Following must be a comparison of the debt-to-equity ratio. These assets may have been obtained through the use of debt or equity.