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.
Table of Contents
A quick intro to profitability
To understand profitability, you need to comprehend how financial statements work.
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.
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.
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 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 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.
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.
Scenario: Your boss asks why the earnings for the IT department declined, but you have no prior information about it.
Framework Application:
Clarify the Objective/Target: You ask if they are aiming to break even or make profits and inquire about the time frame.
Breaking Down the Case: You ask if there’s information about decreased revenue or increased costs.
Drilling Down the Revenues: Discover that there’s a 20% decline in revenue with no change in costs. Further investigate if this revenue decline is due to a decrease in price or volume.
Find that the volume of sales has fallen by 20%.
Outcome: You’ve narrowed down the issue – the decline in profitability is due to a decrease in sales volume. Now, you can move to a more context-based analysis or business framework to understand why this happened.
Example 2: Manufacturing Company Profitability Analysis
Scenario: You are tasked with analyzing the profitability of a manufacturing company.
Framework Application:
Clarify the Objective/Target: Determine if the objective is to break even or make profits and inquire about the time frame.
Breaking Down the Case: Gather information about revenue and costs.
Drilling Down the Revenues: Investigate if there’s any decrease in revenue or increased costs.
Find that revenue has decreased by 15%, while costs have remained the same.
Examine if the revenue decline is due to price or volume changes.
Discover that the price per unit remained constant, but sales volume decreased by 15%.
Outcome: The decline in profitability is attributed to a decrease in sales volume. You can now proceed to analyze the reasons behind this volume decrease, such as market trends or competition.
Example 3: Retail Chain Profitability Assessment
Scenario: You are asked to assess the profitability of a retail chain.
Framework Application:
Clarify the Objective/Target: Understand if the goal is to break even or make profits and inquire about the time frame.
Breaking Down the Case: Collect information about revenue and costs.
Drilling Down the Revenues: Explore if there’s any decline in revenue or increased costs.
Discover that revenue decreased by 10%, while costs remained steady.
Determine if the revenue decline is due to price or volume changes.
Find that the price per unit stayed constant, but sales volume dropped by 10%.
Outcome: The decline in profitability is linked to a decrease in sales volume. You can now investigate factors like market dynamics or customer trends that may have led to this volume decline.
Example 4: Restaurant Chain Profitability Analysis
Scenario: You are tasked with assessing the profitability of a restaurant chain.
Framework Application:
Clarify the Objective/Target: Determine if the goal is to break even or make profits and inquire about the time frame.
Breaking Down the Case: Gather information about revenue and costs.
Drilling Down the Revenues: Investigate if there’s any decline in revenue or increased costs.
Discover that revenue has increased by 5%, while costs have risen by 7%.
Examine if the revenue change is due to price or volume fluctuations.
Find that the price per meal increased by 2%, but the number of customers decreased by 3%.
Outcome: The decline in profitability is attributed to a decrease in the number of customers. You can proceed to explore factors affecting customer footfall, such as menu changes or competition.
Example 5: Software Company Profitability Assessment
Scenario: You are tasked with analyzing the profitability of a software company.
Framework Application:
Clarify the Objective/Target: Understand if the objective is to break even or make profits and inquire about the time frame.
Breaking Down the Case: Collect information about revenue and costs.
Drilling Down the Revenues: Explore if there’s any decline in revenue or increased costs.
Discover that revenue remained steady, but costs increased by 10%.
Investigate if the cost increase is due to variable or fixed costs.
Find that the variable costs have increased significantly due to higher marketing expenses.
Outcome: The decline in profitability is primarily due to an increase in variable costs, particularly in marketing. You can further investigate the effectiveness of the marketing campaigns and whether they align with revenue goals.
Example 6: E-commerce Platform Profitability Analysis
Scenario: You need to assess the profitability of an e-commerce platform.
Framework Application:
Clarify the Objective/Target: Determine if the goal is to break even or make profits and inquire about the time frame.
Breaking Down the Case: Gather information about revenue and costs.
Drilling Down the Revenues: Investigate if there’s any decline in revenue or increased costs.
Discover that revenue increased by 15%, while costs rose by 20%.
Examine if the revenue change is due to price or volume changes.
Find that the number of orders increased significantly (volume increase), but the average order value slightly decreased (price decrease).
Outcome: The decline in profitability is associated with a decrease in the average order value. You can delve into factors influencing customer spending behavior and explore strategies to increase average order values.
Example 7: Pharmaceutical Company Profitability Analysis
Scenario: You are asked to analyze the profitability of a pharmaceutical company.
Framework Application:
Clarify the Objective/Target: Understand if the objective is to break even or make profits and inquire about the time frame.
Breaking Down the Case: Collect information about revenue and costs.
Drilling Down the Revenues: Explore if there’s any decline in revenue or increased costs.
Discover that revenue increased by 8%, but costs also increased by 12%.
Investigate if the cost increase is due to R&D expenses or production costs.
Find that the R&D expenses have surged significantly.
Outcome: The decline in profitability is primarily due to a substantial increase in research and development expenses. You can further evaluate the outcomes of the research initiatives and their potential long-term benefits.
Example 8: Airline Company Profitability Assessment
Scenario: You need to assess the profitability of an airline company.
Framework Application:
Clarify the Objective/Target: Determine if the goal is to break even or make profits and inquire about the time frame.
Breaking Down the Case: Gather information about revenue and costs.
Drilling Down the Revenues: Investigate if there’s any decline in revenue or increased costs.
Discover that revenue decreased by 10%, while costs also decreased by 8%.
Examine if the revenue change is due to passenger numbers or ticket prices.
Find that the passenger numbers dropped significantly.
Outcome: The decline in profitability is linked to a decrease in the number of passengers. You can explore factors affecting travel demand, such as economic conditions or competitive pricing strategies.
Key Highlights
Introduction: Understanding profitability involves analyzing financial statements, which provide insights into a company’s financial health and performance.
Financial Statements: Financial statements include the balance sheet, income statement, and cash flow statement. These documents help assess various aspects of a company’s operations, assets, liabilities, revenues, and expenses.
Balance Sheet: The balance sheet reveals the company’s current financial position by showing how assets are financed through liabilities and equity.
Income Statement: The income statement showcases a company’s revenues and costs over a period, determining whether it operates at a profit or loss.
Cash Flow Statement: The cash flow statement tracks inflows and outflows of cash to assess liquidity and financial sustainability.
Profitability Framework: Narrowing the Problem: Analyzing financial statements requires the ability to focus on relevant data. An analytical mindset is crucial for selecting pertinent information, especially in situations with limited data.
Consultant Mindset: In scenarios where information is scarce and time is limited, adopting a consultant mindset is beneficial. It involves using a bottom-up approach to analyze and solve problems.
Profitability Framework Explained: The profitability framework helps analyze a business’s performance based on limited information. It involves a structured process of asking the right questions to deduce the causes of a decline in profitability.
Income Statement and Framework: The income statement, together with the balance sheet and cash flow statement, is fundamental for analyzing a business. The process starts with the revenue, followed by expenses, and ultimately the net income or loss.
Using the Profitability Framework:
In a scenario where information is lacking, the profitability framework helps deduce the causes of a net loss.
The framework involves constructing a logical argument through a series of questions and hypothesis testing.
Questions focus on revenue and cost factors to pinpoint the root cause of profitability issues.
Applying the Framework:
A case example illustrates how the profitability framework works.
The example involves a scenario where a company’s department experienced a decline in profitability.
The objective is to break even within a specific timeframe.
Step-by-Step Process:
Clarify the objective and target: Determine whether the goal is to break even or make profits and the desired time frame.
Break down the case: Identify whether the problem lies in revenue or costs.
Drilling down revenues: Assess whether the decline in revenue is due to price or volume factors.
Narrowing Down the Issue:
By systematically asking questions, the issue is narrowed down to a specific cause.
In the example, the decline in profitability is traced to a decrease in sales volume.
Further Analysis:
After identifying the root cause, a more context-based analysis or business framework is used to understand the overall market landscape.
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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.
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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).
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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.
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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
