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 Business Concepts

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.

Double-Entry Accounting

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

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
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

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

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

capital-asset-pricing-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
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

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

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:

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