On the types and use of profitability indicators
Profitability indicators show how efficiently a business can use the resources at its disposal.
The basis of profitability
When comparing your sales revenue or any other increase in value, make sure that the accounting only takes into account the value actually realized. When looking at the trends of the indicators over time, you can also count multiple times, but the “sure buy” should be left out of this.
The increase in value is basically shown by sales revenue. Thus, when calculating the profitability indicators, where you see the income, by default, count with your existing sales revenue for a given period.
There are three cases where sales revenue cannot be really interpreted, then write the result of Production Value – Production Cost.
These are the three cases:
- You want to measure the profitability of a part of your business (say a site or industry) and you don’t have the ability to break down revenue exactly.
- Your company works very closely with a larger business. So closely that you are almost a division, meaning you produce for them and only them at a pre-determined, not necessarily lifelike price. It can be a subsidiary, but we can also talk about separate companies.
- You decide to consistently use the difference between production value and production cost instead of sales revenue
Profitability and break – even point
To be able to calculate profitability ratios, you need to know if you have reached the break-even point and, if so, when. To do this, you need to see through your own cost structure.
The minimum production required to reach the break-even point is called critical production.
As you can see in the picture, there are 2 points where sales and costs intersect.
- In the beginning, your income “caughts” the a proportionally high fixed cost,
- In the case of the upper intersection, due to the ever-increasing variable cost, you are no longer generating enough profit to cover it.
When you determine the stage where you can make a profit, be sure to count on the total cost. It can be misleading if you miss something.
Your variable costs may increase due to rising warehousing and shipping costs, overtime, and any more frequent service needs. However, your revenue may decrease because you may only be able to sell larger quantities at a volume discount, or you may be disadvantaged for some other reason.
Thus, the point belonging to the upper margin point is the maximum yield for the given farm size. Profitability ratios between the two show you a positive value. They are useful even if you decide to increase the size and want to plan for the future.
Calculation of profitability indicators
Profitability is an absolute characteristic of operation, it shows whether our revenues exceed our expenditures. For a clearer picture, we can compare income to different productive capacities (be it capital, live labor, or any asset involved in production), then we get the specific income.
Comprehensive analysis of profitability
We compare the total sales revenue to some projection basis to get the efficiency of resource use.
Cost-effective profitability ratio
Profitability ratio = (Income / Cost of production) * 100
The indicator shows the amount of income available at a cost of 1 unit in%. Since you are expected to get at least your own expenses back, it is desirable if your value is above 100%. If this is not achieved, you know that you are either below the critical production point in the image above, or that you have exceeded the limit that represents the production capacity of your maximum operating size.
Profitability ratio on capital
Return on capital ratio = (Income / Capital) * 100
Here, capital can be your total capital, it can be a examined part of it (eg the part involved in production), but you can also break it down according to the direction of fixed assets – current assets.
Profitability ratio in relation to wages
Profitability on wages = (Income / Personnel costs) * 100
The wage-rate profitability indicator shows the efficiency of the use of live labor. It’s also a good idea to look at trends over time, and if you compare your own metrics with other businesses working in a similar industry and similar physical area, you can see how well you’re managing your workforce.
Partial analysis of profitability
When examining profitability, it is not necessarily your goal to see the whole picture. Depending on what your goal is, you may need to look at 1-1 result categories only. The selected result category can be, for example:
- operating profit (EBIT)
- profit before tax
- profit after tax
The goal to be achieved can determine who the analysis is for. For investors, after-tax profit says the most. If you are only interested in profitability, the operating profit from your ordinary activities and the pre-tax profit, which also includes the result of financial operations, are more obvious.
Return on Equity (ROE = Return on Equity)
ROE = (Profit after tax / Equity) * 100
If there is a change in the stock of equity, count on the average here as well.
It shows the return achieved by the owners after fulfilling the obligations. The value of the return on capital is significantly affected by leverage. You can read about leverage in the capital structure indicators.
Return on Assets (ROA)
ROA = (Profit after tax / Total assets) * 100
If there is a change in the stock of assets, calculate the average of assets here.
One of the most commonly used return indicators. It provides an opportunity to compare the efficiency of businesses within the same industry and also to indicate business risk. (A higher result is typically associated with a higher level of risk)
Because we calculate the indicator here in terms of assets, it is not suitable for cross-industry comparisons due to the different asset requirements of different industries.
Return on Investment (ROI)
ROI = (Profit after tax / Investment rate) * 100
In other inscriptions you see a formula of
ROI = ((Revenue – Cost) / Cost) * 100
Notice that the two are one and the same. Profit after tax already includes total revenue, which is reduced by total expenses. And the amount of investment is the amount you have invested in that business. That is, it is a cost to you.
Return on Sales (ROS)
ROS = (Profit after tax / net sales) * 100
It shows how profitable the business was, i.e. how much profit it achieved on 1 unit of sales. Its size is influenced by e.g.
- applied pricing: then your costs will remain, but your net sales revenue will change. An improperly used profit margin degrades the value of the indicator.
- capital structure: the interest paid on the loans has an effect on the after-tax profit, the dividend paid only modifies the balance sheet profit
- industry: a service company may have far fewer items that worsen the after-tax profit, while a capital-intensive manufacturing company has a lot of fixed assets.
- Which of the profitability indicators do you use, and at what intervals?
- How do you plan annual production based on the above?
- Which profitability indicator in your field of activity gives you the most information?
I am happy to read your views either in a comment or through personal contact. Sign up for our newsletter to stay up-to-date on the latest articles.
Recommended posts on business