Mastering profitability analysis: Using profitability ratios to unlock growth in your business

Businesses exist to make money. Of course, some businesses do operate at a loss.  But ultimately, no business can last very long if it isn’t generating a profit.  

So what is profitability, exactly? 

Profitability refers to the ability of a business to generate money above and beyond its expenses. By extension, profitability analysis refers to the process of calculating or analyzing the profits of a business. 

This article will help you understand how to do a profitability analysis and the different ways you can use the information it provides to improve your business. Learning how to do a profitability analysis begins with first understanding what profitability ratios are and what they tell you. So let’s start there.  

What are profitability ratios?

Profitability ratios are used to assess the ability of a business to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders' equity over time using data from a specific point in time. 

Profitability ratios are one five categories of financial ratios that are used to assess different financial aspects of a business. The other four categories are: 

• Liquidity ratios, which measure a company’s ability to meet its short- and long-term financial obligations
• Leverage ratios, which are used to evaluate the level of debt a company may be carrying
• Market value ratios, which are used to determine the value of a company’s stock
• Efficiency ratios, which measure how efficiently a company is using its resources

Profitability ratios are a critical component of profitability analysis. However, they are not the only aspect of a company’s finances that must be evaluated to determine its profitability. A comprehensive profitability analysis also involves examining revenue streams, analyzing expenses, benchmarking performance, identifying trends, and making data-driven decisions based on the insights gained.

With a comprehensive profitability analysis, you can assess your company's financial health and make informed decisions about pricing, cost management, and resource allocation. By analyzing and plotting historical profitability data, you can also forecast future profitability and plan for growth, which is valuable information for stakeholders, investors, and decision-makers.

The different types of profitability ratios used in profitability analysis

Ratio analysis is the primary component of profitability analysis. This makes sense because quantitative results are often better understood when presented as a percentage.  

There are two main types of profitability ratio used in a profitability analysis –  margin ratios and return ratios. 

Margin ratios

Margin ratios are strategic financial metrics that measure a SaaS company's profitability at various levels of its income statement. They express profit as a percentage of revenue. 

Margin ratios help stakeholders understand how efficiently a company generates profit from its core operations, manages its expenses, and converts revenue into bottom-line profits. Thus, they provide crucial insights into the company's financial health and performance.

Below are the five types of margin ratios.

1. Gross profit margin

Gross profit margin (or gross margin) measures the percentage of revenue that remains after subtracting the cost of goods sold (COGS) aka the company’s ability to generate profit from its core products or services. Gross profit margin provides insight into a company's pricing strategy, production efficiency, and overall profitability.

2. Operating profit margin

Operating profit margin calculates the percentage of revenue that is left after accounting for all possible operating expenses, such as salaries, rent, and utilities. 

It reflects a company's profitability from just its core business operations, excluding non-operating income and expenses, such as interest and taxes. A higher operating profit margin indicates that a company efficiently manages its operating costs.

3. Net profit margin

Net profit margin measures the percentage of revenue that remains as net income after accounting for all expenses, including taxes and interest. This is where you would also account for other non-sales revenue income that you might have in your business. 

Net profit margin provides a comprehensive view of a company's overall profitability. In comparison to operating profit margin, net profit margin takes into account non-operating expenses, providing a more complete picture of a company's bottom line.

4. Cash flow margin

Cash flow margin calculates the percentage of cash a company generates for each dollar of revenue over a given period (i.e., how easily the company is able to convert revenue to cash). This is an indicator of profitability. 

Remember that profit is whatever cash is left over after all expenses are deducted from your revenue. A lower cash flow margin means the company is retaining less of its revenue after expenses, which translates into a lower profitability.   

EBITDA margin

Earnings before interest, taxes, depreciation, and amortization (EBITDA) margin measures a company's operating profitability specifically, which as the term EBITDA suggests, does not consider non-operating expenses, such as interest, taxes, depreciation, and amortization. 

The higher the EBITDA margin, the smaller a company’s operating expenses are in relation to its total revenue, leading to a more profitable operation.

Return ratios

Return ratios are financial metrics that help measure a company's profitability in relation to the resources it has invested, such as assets, equity, or capital employed. 

These ratios are essential to gauge how efficiently a company generates profits and utilizes its resources. With these ratios, you can make informed investment decisions, resource allocation, and overall financial management.

The four main types of return ratios are described below.

1. Return on assets

Return on assets (ROA) measures how efficiently a company utilizes its assets to generate profits. The higher the ROA, the more effective a company is in using its assets to generate earnings. 

ROA is useful for comparing the profitability of companies within the same industry, as it eliminates differences in financing structures.

2. Return on equity

Return on equity (ROE) measures the profitability of a company in relation to the equity invested by shareholders. ROE helps understand how well a company uses investors' money to generate profits. 

A higher ROE suggests that a company is more efficient at creating profits from the equity invested.

3. Return on capital employed

Return on capital employed (ROCE) assesses a company's profitability relative to the capital employed that includes both equity and long-term debt. It measures the efficiency of capital allocation. 

4. Return on investment

Return on investment (ROI) measures the profitability of a specific investment or project by calculating the return generated relative to the cost of the investment. 

Difference between profitability ratios and efficiency ratios

Profitability ratios and efficiency ratios are two different categories of financial metrics that can provide unique insights into a company's financial health. 

Profitability ratios, such as the ones mentioned above, measure a company's ability to generate profits within a specified context. For SaaS businesses, profitability ratios help determine the viability of their pricing models, the effectiveness of their cost management strategies, and their overall financial performance.

On the other hand, efficiency ratios indicate how effectively a company is utilizing its resources to generate profits. These ratios include:

• Customer acquisition cost (CAC): CAC represents the incremental cost of acquiring a new customer, including marketing and sales expenses. A lower CAC means the company is more efficient in acquiring customers, leading to higher profitability. 
• ‍Customer lifetime value (LTV): The LTV: CAC ratio provides insight into the long-term profitability of a SaaS company's customer acquisition strategies.
• Rule of 40: The SaaS Rule of 40 suggests that a SaaS company's combined growth rate and profitability (measured by EBITDA margin) should be at least 40%. This rule measures the overall health of a SaaS business. To attract investors, SaaS companies must ideally balance growth and profitability and ensure sustainable expansion.

While profitability ratios and efficiency ratios measure different things, they are inherently interrelated. Efficiency ratios directly impact a company's profitability by optimizing resource utilization and minimizing costs. By continuously improving the efficiency ratios, SaaS businesses can also steadily enhance their profitability and achieve long-term success.

How to evaluate profitability (or the potential for it) in early-stage startups

For early-stage, pre-revenue SaaS companies and those that are generating revenue but not yet making a profit, looking at the contribution margin and doing a break-even analysis are two ways to understand their potential for profit. 

Contribution margin

The contribution margin is the difference between the subscription price and the variable cost per customer. This information serves as a proxy for profitability by helping companies understand how much each customer contributes to covering fixed costs and generating profit. 

By analyzing the potential contribution margin, pre-revenue companies can make informed decisions about how to price their subscription plans, the cost structure of their operations, and the number of customers they need to reach profitability. This information can also go a long way in attracting investors, securing funding, and planning for scalable growth.

Break-even analysis

For pre-revenue companies and those that may be generating revenue but are not yet making a profit, a break-even analysis is also a useful tool, particularly for SaaS companies, which often operate “in the red” for some time before achieving profitability.

As the name suggests, break-even analysis helps these businesses determine the point at which their revenue equals their total costs. Their break-even point is when they are neither making a profit nor losing money.  This analysis allows businesses to set realistic sales targets, make informed pricing decisions, and develop strategies to achieve profitability.

How to perform a profitability analysis for your business 

There are 4-5 main steps required to perform a thorough profitability analysis, depending on whether your company is or is not currently profitable.

Step 1: Gather the data and key financial statements needed for analysis 

To conduct a comprehensive profitability analysis, you'll also need access to several key financial statements. These include:

• Income statement (also known as the profit-and-loss statement), which provides an overview of your company's revenue and expenses.
• Balance sheet, which lists your assets, liabilities, and equity.
• Cash flow statement, which tracks the inflow and outflow of cash in your business. 

You’ll also need to gather all relevant data from other financial reports that can provide information into a company's performance, including your core SaaS and financial metrics.

For example, when conducting a profitability analysis, SaaS companies must consider several key factors that impact their bottom line, such as customer acquisition cost (CAC) and lifetime value (LTV). These are important metrics because to achieve profitability, companies must ensure that the customer lifetime value (LTV) exceeds their CAC.

It’s also important to have historical data if available, as it can be used to evaluate trends along your journey to profitability. 

Note that it is imperative that the data you use in your analysis is accurate and up-to-date in order to gain a realistic view of your company's financial performance.

Step 2: Calculate your break-even

This step is critical for early-stage startups that have yet to generate profits. If your company is already profitable, you can skip to the next step. 

Calculating your break-even point (the point at which your company is not generating profit but also not losing any money either), you can more effectively set sales targets, adjust pricing strategies, and make informed decisions about cost management.

Step 3: Perform a ratio analysis

Ratio analysis is all about calculating and interpreting various financial ratios to assess your company's profitability. 

Once you have gathered the necessary financial data and key statements, you can then calculate the profitability ratios that are most relevant to your business. 

This process can be done using spreadsheets, but it can be quite cumbersome as you might have to manually pull together the required data from different sources. 

Using a financial planning and analysis (FP&A) software can significantly streamline this process because it can automate data consolidation, which reduces the risk of error and saves time that you can use to focus on analyzing the results. 

Step 4: Benchmark your results

While conducting the profitability analysis is a key part of this exercise, another critical step is to benchmark the results against industry standards. This includes comparing your performance to that of your peers, as well as considering the impact of larger macroeconomic factors on your business. 

Benchmarking gives you a basis for comparison, helping you identify areas where your company excels or lags. You can also make benchmarks actionable in your business to set more realistic targets and develop strategies for improvement. 

Step 5: Interpret the results to make informed business decisions

The final step is to interpret the results. The tables above will help you understand what your ratios are telling you about your business. Look at each ratio to see what it suggests about where you can reduce costs, optimize pricing strategies, or invest in growth opportunities to become more profitable.

By regularly monitoring your profitability ratios and benchmarking your performance against industry standards, you can continuously improve your financial health and drive long-term success for your business.

The challenges and “profit” in profitability analysis 

Profitability analysis is undoubtedly a powerful tool with many benefits. However, doing a comprehensive analysis is not without its challenges. Let’s look at some of those challenges here. Then we’ll discuss the benefits you can achieve if you overcome them.  

Here are some of the key challenges that can throw your profitability analysis off-track:

• Inaccurate cost allocation: One of the often overlooked challenges is the inaccurate allocation of costs to specific products, services, or business units. If costs are not allocated correctly, it can lead to a heavily distorted view of profitability.
  
  Additionally, businesses might risk overlooking cash flow and cash flow margin in their profitability assessments. Ignoring cash flow can lead to a false sense of profitability as it represents the actual inflow and outflow of money.

• Lack of data accuracy: The accuracy of your profitability analysis  is dependent on the quality of your financial data. If any of the data used in the analysis is incomplete, inconsistent, or erroneous, it can lead to misleading results and incorrect conclusions. 

• Ignoring indirect costs: Indirect costs, such as overhead expenses, administrative costs, and depreciation, can significantly impact a company's profitability. Failing to account for these can lead to an overestimation of profitability. 

• Failure to consider the time value of money: The time value of money is the concept that money available today is worth more than the same amount of money in the future due to its potential to earn interest.
  
  When conducting profitability analysis, companies must use techniques such as discounted cash flow analysis to account for this. 

• Lack of clear performance metrics: To effectively measure and analyze profitability, companies need to establish clear performance metrics that align with their business objectives. Without these, it would be hard to identify areas for improvement. 

• Limitations of profitability analysis tools: There are various tools and techniques available for conducting profitability analysis. However, they may have limitations in providing a comprehensive assessment as they might not account for factors such as market conditions, competitive landscape, and customer preferences. 

To overcome these limitations, it is best to use a combination of profitability analysis tools and techniques, such as scenario analysis, sensitivity analysis, and benchmarking, to gain a more holistic view of financial performance.

SaaS-specific challenges

In addition to the challenges described above, SaaS companies have a few additional obstacles due to the nature of the SaaS business model, which involves recurring revenue streams, complex pricing structures, and evolving customer relationships.

One of the primary challenges is the impact of one-time expenses and revenue items, such as implementation fees, setup costs, or one-time discounts. These non-recurring items can distort the overall profitability picture. 

To ensure accurate trend analysis, SaaS companies must identify and exclude these one-time items from their profitability calculations. Though this process can be complex and time-consuming, it is essential. 

Another significant challenge for SaaS businesses is having the right information at the right level and ensuring its accuracy. Profitability analysis in SaaS involves slicing and dicing data. SaaS businesses often have different pricing tiers and product lines and operate in different geographies, and it is important to account for all of them. 

This granular analysis requires a system that can capture the data accurately by integrating with various data sources and calculating the right allocation ratios. A purpose-built financial planning and analysis (FP&A) tool is ideal for this purpose.   

The profit (aka benefits) of profitability analysis 

Performing a profitability analysis provides numerous benefits to businesses, including making informed decisions, optimizing their operations, and driving long-term success. 

Profitability analysis can empower businesses to:

• Improve visibility and decision-making: By assessing various profitability metrics, businesses can better understand their strengths and weaknesses. This then enables the management to make data-driven decisions that align with the company's goals and objectives. 

• Identify what is generating the highest profits for your business: With profitability analysis, you can identify your most profitable customers, products, geographies, etc. By analyzing the revenue and costs associated with each segment, companies can determine which groups generate the highest profits and which may be draining resources. This allows businesses to focus efforts on areas where they have easy wins.

• Increase cash flow: Through profitability analysis, companies can identify areas where they can reduce costs and improve operational efficiency. By streamlining processes, eliminating unnecessary expenses, and optimizing resource allocations, businesses can increase their cash flow and improve their overall financial health. With this increased cash flow, the company can invest in growth opportunities, pay down debt, or distribute dividends to shareholders.

• Optimize costs: By analyzing the costs associated with each product, pricing tier, or geography, companies can determine which areas are most cost-effective and which may require adjustments. With this information, they can make more informed resource allocations and cost management decisions, ultimately leading to improved profitability.

• Identify areas for growth: By conducting a comprehensive profitability analysis, companies can identify areas with the highest potential for growth. This may involve expanding into new markets, developing new products or services, or acquiring complementary businesses.

Profitability ratio analysis not only benefits the company itself but also prepares analysts and potential investors to evaluate how well the company is performing compared to its competitors. This ‘under the hood’ information of sorts is essential for making informed investment decisions and assessing the overall attractiveness of a company. 

Leverage technology for enhanced profitability analysis 

To effectively conduct profitability analysis, businesses really need the ability to slice and dice their financial data to identify which aspects of the business are moving at a good pace, which are holding steady, and which are underperforming. 

This granular analysis can often be a complex and time-consuming process, especially for growing businesses with multiple revenue streams and cost centers. 

Drivetrain is a powerful FP&A platform that can seamlessly consolidate all your financial data in a single place, making it easy to conduct comprehensive profitability analysis.

With Drivetrain, you can integrate data from various sources, such as your accounting software, CRM, and billing systems, ensuring that all your financial information is accurate and up-to-date. The platform's intuitive interface and powerful analytics tools allow you to get a fine-grained view of your data, create custom reports, and visualize your financial performance in real-time.

By leveraging Drivetrain's financial reporting and financial planning and analysis capabilities, you can streamline your profitability analysis process, gain deeper insights into your business performance, and make informed decisions that drive growth and profitability.

Check out Drivetrain today to learn more about how it can power your profitability analysis.