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.
- A quick intro to profitability
- The profitability analysis framework explained
- The Profitability Framework: Narrow The Problem
- Step 1: Clarify the objective/target.
- Step 2: You start breaking down the case in your head.
- Step 3 You drill down the revenues.
- Connected Business Concepts
A quick intro to profitability
To understand profitability, you need to comprehend how financial statements work.
In other words, for a company to understand how it’s doing from a financial standpoint, it needs to be able to track its performance through three main financial documents:
- Balance Sheet.
- Income Statement.
- And Cash Flow Statement.
The balance sheet helps a company to gain an understanding of where it’s right now in terms of having acquired its assets.
In other words, when you build assets for your business, usually you have done that in two ways: either by taking short or long-term leverage (debt) or by taking equity (putting more money into the business, enabling others to invest, or re-invest back the profits the organization generates).
The balance sheet is a key document to understand how a company is doing from a financial perspective.
And whether its revenues cover the costs (in which case the organization incurs a net profit) or if the organization cannot cover the costs with its revenues (in which case the organization incurs a net loss).
Profitability intersects within a balance sheet’s equity section, where dividends are part of building up equity over time.
And therefore, you’re growing the business by increasing its assets rather than its liabilities!
That is why understanding how profitability works is critical, and through the profitability framework, you can have a quick snapshot and understanding of how a company’s profitability flows into the business and determine the root causes for that.
The profitability analysis framework explained
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 broad spectrum of data, the one that is relevant to perform the analysis.
Therefore the analyst mindset is one of the abundance 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 develop a scarcity mindset quickly.
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.
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 will use the “profitability framework.”
This starts from the assumption that we do not have any information about the business, but we know that the company 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 is revealed 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:
- 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).
- 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 the Cost before you start drilling down. Therefore, you ask:
- 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?
Connected Business Concepts
Other ways to assess profitability:
- Gross Profit Margin
- Operating Profit Margin
- Return on capital employed
- Return on Equity
- Business Model
- Business Engineering
Other key resources:
- Business Frameworks
- Business Analysis Framework
- Cash Flow Statement In A Nutshell
- How To Read A Balance Sheet Like An Expert
- Income Statement In A Nutshell
- What is a Moat?
- Gross Margin In A Nutshell
- Profit Margin In A Nutshell
- What is a Financial Ratio
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- The Complete Guide To Business Development
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