To analyze companies profits a number of tests are available to tell us what shape a business is in. Profitability analysis uses a series of different tests in looking at a company’s performance during a fixed reporting period.
The results that surface when used with other data can enable you to make an informed forecast about future profitability.
The profit potential is crucial in a business because to attract shareholders and long-term stakeholders like banks and investors the business models must be profitable.
Whether you are buying a small business or a franchise doing a full profitability analysis is a wise move.
The results if combined with other data that I will detail below, can forecast the company’s potential profitability. Profit potential is important to long-term creditors and shareholders because, in the end, the company must operate at a satisfactory profit to survive.
Showing profits on the books is very important to everyone that will have access to the companies reporting statements, people that will include lenders and trade creditors. They all have a stake in knowing that the business is profitable.
The best way to do a profit analysis is to look at the total assets that a business has then study the relationship between profit and sales.
Do shareholders currently take profits from the business each year?
If the profits showing do not look to be a large amount there could be many reasons why. Asking the following questions might help to provide an answer.
1. What are the current sales volumes like?
2. Are the costs associated with each sale too high?
3. Does the business have too much money invested in assets that do not relate directly to sales?
4. Do the assets that the business has return a profit to the business?
A calculation that you can use to measure asset return is to divide the total net profit
Amount the business is showing (before tax) by the value of the assets the company holds.
If the figure is one that is becoming smaller each year it will show that expenses are rising faster than sales income is growing.
How Can I work out what the real Net Profit Margin is?
Financial analysts and accountants call this figure the net profit ratio.
We arrive at the net profit ratio by taking a vertical analysis of the statement called the profit and loss statement. This figure will reveal the amount in each dollar of every sale made that represents profit. To get this crucial and often revealing figure we simply divide the business operating profits before tax by the net sales figure.
Margin of Gross Profit
To measure what the margin of gross profit in a business is we simply need to work out what each dollar of sales returns before attaching expenses. If we make a sale for one dollar and the business margin is forty-five cents, we have a 45% gross margin.