profitability

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.

A quick intro to profitability

To understand profitability, you need to comprehend how financial statements work.

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

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 fact, in very simple terms, a balance sheet stands on a very simple equation called an accounting equation which tells you that assets = liabilities + equity.

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.

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).

The balance sheet and income statement are connected. In fact, an income statement is a simple document that shows the revenues and costs the organization carries.

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 fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

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.

For instance, imagine a business that generates $1000 in profits, and it re-invests them all back into the business.

Now, on the balance sheet, you will find, under equity, an equivalent amount, and under assets (either cash or equivalents), the same.

This means that if you’re re-investing profits into the business, you’re also increasing the asset section of the balance sheet.

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

Analyzing financial statements is one of the most crucial skills to acquire if you want to work in financial accounting, strategy, and 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 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.

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.

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).

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: 

  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 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.

How?

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 Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

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 sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

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).

Income Statement

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 fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with 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.

Capital Structure

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 endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, 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.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

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.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

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.

Triple Bottom Line

triple-bottom-line
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

behavioral-finance
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Connected Video Lectures

Other ways to assess profitability:

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