Profitability is key to the success

For every business to be successful and remain in business it needs to be profitable. Profitability is very important for long-term survival. For every commercial concern, profitability is the main corporate goal.
Every investor gets into business to earn a return so every business should make money for its shareholders. It is therefore very critical for managers and investors to be able to measure a company’s current profitability.

For start-ups, it’s very important to focus on profitability right at the beginning of the company. There are profitability ratios that can be used to monitor how the business is performing.
The income statement is a key component of the financial statements that is used in computing profitability ratios. The ratios are divided into two types: margins and returns.
Ratios that show margins represent the firm’s ability to translate sales dollars into profits at various stages of measurement whereas ratios that show returns represent the firm’s ability to measure the overall efficiency of the firm in generating returns for its shareholders.

The margin ratios are made up of the gross profit margin, operating profit margin and the net profit margin.
The gross profit margin looks at the cost of goods sold as a percentage of sales. This ratio looks at how well a company controls the cost of its inventory and the cost of manufacturing its products and subsequently pass on the costs to its customers.

The margin is calculated as gross profit divided by net sales. The larger the gross profit margin ,the better for the company. Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development, marketing and other selling, distribution and administration costs.
A company needs to lookout for downward trends in the gross profit margin rate over time. A decline in the gross profit margin is a tell-tale sign of future problems facing the company.
To address this problem, a company will have to control labour and material costs or the company can pass these costs onto customers in the form of higher prices.
The operating profit margin looks at its earnings before interest and taxes (EBIT) as a percentage of sales. The operating profit margin ratio is a measure of overall operating efficiency, incorporating all of the expenses of ordinary, daily business activity.

This equation assesses how the company’s revenues are covering all company’s expenses. The calculation of the operating profit margin is EBIT/Net Sales. A high operating profit margin can mean the company has effective control of costs, or that sales are increasing faster than operating costs.
The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation. The calculation of net profit margin is calculated as Net Income/Net Sales.
The other profitability ratios are returns ratios which are composed of return on assets and return on capital employed.
The return on assets is an important profitability ratio because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm’s level of investment in total assets.

The calculation for the return on assets ratio is Net Income/Total Assets. A higher percentage is better because that means the company is using its assets well to generate sales.
The return on equity is the most important of all the financial ratios to investors in the company. It measures the return on the money the investors have put into the company.
It is the ratio potential investors look at when deciding whether or not to invest in the company. The calculation of the return on equity is Net Income/Stockholder’s Equity.
A higher percentage shows that the company is using the investors’ money efficiently.

The above profitability ratios will help in determining whether a company is making profits.
As discussed above, the main aim of a business is to earn profits. To achieve this objective, a company should attract and retain those customers who are profitable. This can be determined by carrying out a customer profitability analysis.

A profitable customer can be defined as a person or company that, over time, yields a revenue stream that exceeds by an acceptable amount the company’s cost of attracting, selling, and servicing that customer. Therefore customer profitability analysis calculates the revenue coming from each customer less all costs associated with attracting, selling, and servicing that customer. A business should aim to retain those customers that are profitable.

The other area that needs to be analysed is customer product profitability analysis. Since businesses have a wide variety of products, it’s important for a company to establish the profit the company is getting from that customer per product.
This profitability analysis can help find out both the profitable customers as well as profitable products. Any products or customers not contributing to the profitability of the company should be cut off because they are just a drain to the company’s limited resources.

For a company to remain profitable it therefore needs to produce products which are competitive in the market because of their good pricing. A company can adopt a cost leadership strategy as one of its sustainable competitive advantages.
A company should therefore take care of its costs which will subsequently bring its profitability. Low costs can be translated into customer benefits which will attract customers resulting in increasing the overall company profitability.

To maintain its competitive advantage a company should also ensure that it continuously improves its products and processes. Adoption of a total quality management (TQM) philosophy will ensure that the company meets customer expectations. TQM involves everyone in the organisation from top management to the workforce and also suppliers and even customers. A TQM approach helps in reducing costs and improving on quality of products.

Applying a profitability analysis will lead to the company discovering the areas where it is profitable and those where it is not. A company can then decide where it should lower the cost and where it can increase value.

l Stewart Jakarasi is a business and financial strategist and a lecturer in business strategy (ACCA P3), advanced performance management (P5) and entrepreneurship.
He is the Managing Consultant of Shekina Consulting (Pty) Ltd and provides advisory and guidance on leadership, strategy and execution, corporate governance, preparation of business plans, tender documents and on how to build and sustain high-performing organisations.

For assistance in implementing some of the concepts discussed in these articles please contact him on the following contacts: sjakarasi@gmail.com, call on +266 58881062 or WhatsApp +266 62110062 .