Profitability Framework To Quickly Analyze Profitability

A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

The profitability analysis framework explained

Analyzing financial statements is one of the most crucial skills to acquire if you want to work in financial-accounting-2">financial accounting, strategy, investing, and a good business skill to master.

However, analyzing financial statements implies that you have all the needed information to perform your analysis.

The word “analytical” means being able to select from a wide spectrum of data, the one that is relevant to perform the analysis.

Therefore the analyst mindset is one of the abundances of information.

In a world that constantly evolves and becomes more complex, there may be situations in which information is very scarce.

Consequently, we have to quickly develop a scarcity mindset.

One in which no information is provided, however, an answer is required in a short amount of time.

How do we deal with such situations?

It is crucial to develop a consultant mindset.

Thus, instead of using Top-Down approaches, typical of the managerial accountant, we have to use a bottom-up approach, typical of a consultant. 

The Profitability Framework: Narrow The Problem

Imagine this scenario: One day, you are in your office. The boss comes in and he asks for your opinion.

He wants to know why the earnings for the IT department declined.

You do not have an idea of what he is talking about and never had any exchange whatsoever with the IT department in the last couple of years.

What are you going to answer?

That is where the “profitability framework” helps.

The Income Statement, together with the balance sheet and cash flow statement, is among the main financial statements to look at to analyze a business.

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at a fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at a profit or loss (also called the P&L statement).

It starts by showing the revenue, then expenses, and eventually the bottom line: the income">net income.

This implies that we have all the information we need to understand how the Net Income/Loss was generated.

Let’s go back to the scenario I asked you to imagine at the beginning of the paragraph.

Remember, the boss or your client asks you on the spot an opinion about something we don’t have any information about.

There is no time and not even an Income Statement to look at.

The only information about the business cannot be accessed visually. The only way to access it is through questions.

Therefore, it is crucial to ask the right questions, two to five to assess the situation.

To structure our thinking process we are going to use the “profitability framework”.

This starts from the assumption that we do not have any information about the business but we know that the business had a loss.

This implies a sort of reverse engineering of the Income Statement using the falsification process from the scientific method.

Consequently, you will start from the net profit/loss, devise a hypothesis and test it.

The profitability framework is like a reversed income statement and it will look like the following:

Once tested the hypothesis if it reveals to be true, you have to cross this framework with another business framework to have the answer you are looking for.

To test the hypothesis we have to devise a logical argument. 

This argument will look like an algorithm where you will ask for example: Did our revenue decrease?

If yes, then drill down and figure out whether the issue relates to the price or the volume.

If not, then move on and ask: Did the expense increase?

If yes, drill down further to understand whether the issue is in the variable or fixed cost.

Once established where the issue is, you will switch to a business framework to assess whether it was a problem of competition, customers, market, and so on.

For example, John, the CEO of your organization, comes to you and says: “Department XYZ, an electric company experienced a decline in profitability (Net Loss), we have a board meeting in six months, how do we improve its profitability?”

Before we assess the how we have to find the why, in three simple steps and five simple questions. 

Step 1: Clarify the objective/target.

You want to know: what are they looking for? (Break even or make profits) and what is the time frame.

Therefore you ask: 

  1. Are we trying to break even or to make profits? (perhaps if a company is entering a market, breaking even or also losing money might be a short-term strategy to gain market shares).
  2. What is your time frame? 

The CEO explains that they are looking to break even in six months. Before the board meeting is hosted. Perfect. 

Step 2: You start breaking down the case in your head.

You know that profits are comprised of revenue and cost.

Furthermore, you want to understand whether the problem is in the Revenue or in the Cost before you start drilling down. Therefore, you ask:

  1. Do we have any information about decreased revenue or increased costs? 

The CEO explains there was a decline in revenue by 20% while the costs remained the same over time. Great. 

From this simple answer, you can already exclude half of the framework (the cost side) and focus on the other half (the revenue side). See below:

Step 3 You drill down the revenues.


Revenue is comprised of Price per unit and Volume. In this step, you will try to assess whether the 20% decline in revenue was due to a decrease in price or a decrease in sales volume.

Therefore you ask:

Has the price declined? 

The CEO says the price stayed the same. 

Furthermore, you ask:

Has the volume declined?

The CEO confirms the volume has fallen by 20%. 

 The good news is that you have narrowed the issue down in just a few minutes. Indeed, your framework will look like the following: 

This leads to the end of the first stage. Indeed, we figured out “what” is causing the issue.

In fact, the decrease in profitability is due to a decrease in volume of sales volume.

How this has happened?

From there, you can move to a more context-based analysis or business framework that looks at the overall market landscape.  

Connected Business Concepts

Financial Modeling

Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Double-Entry Accounting

Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheetincome statement, and cash flow statement). The basic concept of double entry is that a single transaction, to be recorded, will hit two accounts.

Accounting Equation

The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company’s balance sheet can be broken down into assets, and how they get sources (either through equity/capital or liability/debt).

Financial Accounting

Financial accounting is a subdiscipline within accounting that helps organizations provide reporting related to three critical areas of a business: its assets and liabilities (balance sheet), its revenues and expenses (income statement), and its cash flows (cash flow statement). Together those areas can be used for internal and external purposes.

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Capital Structure

The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowments from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

CAPM Model

In finance, the capital asset pricing model (or CAPM) is a model or framework that helps theoretically assess the rate of return required for an asset to building a diversified portfolio able to give satisfactory returns. 

Capital Expenditure

Capital expenditure or capital expense represents the money spent toward things that can be classified as a fixed assets, with a longer-term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Cash Flow Statement

The cash flow statement is the third main financial statement, together with the income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing, and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Income Statement

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at a fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at a profit or loss (also called the P&L statement).

Other ways to assess profitability:

Other key resources:

$200 Off Library
No prize
Next time
$300 Off BMI Course
50% Off Flagship Book
No Prize
No luck today
Unlucky :(
No prize
Get your chance to win a prize!
I have read and agree to the Privacy Policy
Scroll to Top