Fri. Aug 12th, 2022

    Goal of Profitability Analysis

    A successful business is an effective and efficient business. Efficiency is the optimization of resources devoted to achieving objectives. In financial analysis, the effectiveness and efficiency of a business is measured using profitability analysis indicators.

    Profitability is the ratio of a profit to the capital necessary to achieve that result. The information transmitted by the profitability calculation does not have the same meaning depending on whether you are a partner or an executive.

    This is two indicators are calculated:
    – economic profitability mainly interests managers:

    Economic profitability = Operating result / Capital invested

    – financial profitability mainly interests the partners:

    Financial profitability (or equity) = Net income / Equity

    Leverage is the influence of a company’s financial structure on its financial profitability.

    Read also: Profitability Ratio Analysis and Fundamental Analysis Criterion | Formulas and Examples

    1. Definition of profitability

    The notions of profitability and profitability should not be confused. Profitability is the ratio of a result to a level of activity (turnover for example). Profitability is the ratio of a profit to the capital necessary to achieve that result.
    Profitability is the ability of a business to generate profit. The information transmitted by the profitability calculation does not have the same meaning depending on whether you are a partner or an executive. This is why two indicators are calculated:
    – economic profitability mainly interests managers,
    – financial profitability mainly interests the partners.

    The main limitation in calculating profitability is that risk is not taken into account.

    2. Economic profitability: the manager’s point of view

    Economic profitability measures the return on capital employed, that is, the ability of the company to generate profits from invested capital. To take into account only the “normal” (therefore recurring) activity of the company, operating income is used (financial and exceptional items are therefore excluded). The invested capital corresponds to the value of the gross fixed assets plus the value of the operating working capital requirement. Economic asset is a term equivalent to invested capital.

    Economic profitability = Operating result / Capital invested

    3. Financial profitability: the partner’s point of view

    Return on equity (or return on equity) measures return on equity, that is, the company’s ability to remunerate partners. To attract investors or not to “lose” current partners, the company aims to maximize this indicator.

    Financial profitability (or equity) = Net income / Equity

    4. Leverage

    Leverage is the influence of a company’s financial structure on its financial profitability. The use of bank indebtedness increases financial profitability on condition that the company borrows at an interest rate lower than the economic rate of return.