FAQ | How Can you Improve your Business’s Profitability?

When a business makes a profit (i.e., when it generates income from the money it invested), you can then talk about profitability, which can be measured in different ways regardless of how substantial the profit is. To be able to operate and generate enough long-term profit, a business must sometimes consider financial optimization. Profitability helps assess a business’s performance and its capacity to finance its growth.

It enables a business to finance its growth, attract investors and ensure sustainability. A positive level of profitability demonstrates a good use of resources, a competitive advantage and a greater appeal for investors.

It is calculated by comparing profits earned on the investment with capital invested.

Rate of return = net earnings/capital invested

The steps in that calculation are the following:

• Estimating cash flows;
• Updating cash flows;
• Determining a project’s internal rate of return (IRT).

The IRT is commonly used to assess a project’s long-term profitability. You calculate that rate starting with the initial investment, taking into account the project’s useful life, and measuring its average annual return as well as its final value (actual or projected).

By combining several key indicators, you get an overview of a company’s financial performance. The main elements to consider are its operational efficiency, its profitability and its liquidity. These are some key indicators:

• Return on equity (ROE);
• Return on assets (ROA);
• Gross margin;
• Net margin;
• Liquidity ratio;
• Debt ratio.

What is regarded as a good profitability ratio depends on your business’s industry and context. A number of factors must be considered.

It’s the difference between the revenue generated by a product and its associated costs. Here are some steps to calculate a product’s profitability:

• Isolate total sales;
• Identify variable overhead costs (cost of raw materials, direct labour and packaging, and other variable product-related expenses);
• Calculate the contribution margin;
• Identify and allocate all fixed overhead costs (cost of indirect labour, rental expense, salaries of sales and administrative teams, insurance and other fixed product-related expenses);
• This will enable you to calculate profitability and to subtract fixed overhead expenses from the contribution margin.

You must first do a profitability analysis by:

• calculating your production costs;
• determining the profitability of each of your products and services, as well as of your customers and market.

You must also get a clear picture of your business to be able to make a diagnosis by:

• determining your organization’s strengths and weaknesses;
• determining your business’s external strengths and weaknesses, in particular regarding your position on the market.

You must then draw up a strategic plan and an action plan to:

• improve efficiency;
• select promising investment projects;
• make business decisions (letting some customers go, discontinuing some products, negotiating or revising your pricing, etc.).

It’s an indication that a business efficiently manages its costs versus its sales:

• To calculate corporate profitability (in percentage), use the following formula: net earnings/sales × 100;
• A benchmark test will allow the business to compare its performance with that of other companies in the same industry sector.

Benchmarking means comparing a business’s performance with that of its peers. It is indeed possible, using data collected by Statistics Canada, to assess business practices in your industry sector, in particular by comparing quarterly sector performance indicators such as profitability and efficiency ratios.

This benchmark test provides a clear picture of a business and helps thus evaluate its strengths and weaknesses. At the same time, benchmarking is a tool to identify the necessary actions and desired goals to improve the situation.

A business will first have to do a costing analysis. As a reminder, costing (or production costs) is determined by the sum of all expenses needed for producing a good or offering a service.

It is used to set the selling price of goods and services and to assess their profitability. By extension, it helps identify which customers are profitable.

The famous Pareto principle leads us to believe that 20% of a company’s customers generate 80% of its profits and, conversely, that 80% of its customers generate 20% of its profits. Our own observations actually reveal that, particularly in the manufacturing sector, 40% of customers generate 320% of a company’s profits, 34% of its customers generate 0% of its profits and 26% of its customers generate 220% of its losses.

Let’s take the example of a business generating $50M in revenue with net earnings of $2M, i.e., a low ratio of 4%. Yet, this business has customers generating $4M in net earnings as well as less profitable customers costing $2M in net losses, even though they represent 40% of total sales. The business could easily turn things around and double its net earnings to reach $4M.

After analysis, in some cases, the business could be justified in adjusting and increasing its prices, explaining to customers the reason for the change and thus orientating its strategy towards profitable customers.

In this way, the business will have increased its value and improved its profitability at the same time, without undertaking a big reengineering project. The market value of a company is indeed determined using the earnings before interest, taxes, depreciation and amortization (EBITDA), which is then multiplied by a coefficient usually set between 4 and 5, to get the company’s theoretical value. A higher EBITDA will therefore increase the business’s value.

Several elements and ratios can be used to determine a business’s profitability. This article will help you identify some of the key indicators you should assess by looking at your financial statements, for example.

Activity-based accounting is a way to allocate overhead and indirect costs to goods and services considering the activities necessary for their production. The main steps are as follows:

• Identifying the activities;
• Allocating costs to activities;
• Calculating drivers;
• Affecting costs to goods or services.

Liquidity represents a company’s ability to meet obligations associated with its financial liabilities in a timely manner. This ability considers both available cash and the deadline requirements to convert assets into cash.

For example, a business can first sell inventories or services and then collect the amounts receivable on such goods and services in a relatively short timeframe. These elements will be assessed to calculate all of the liquidities the organization can access to meet its obligations, considering the timing of its scheduled payments.

Liquidity is very important for a business. It must have enough liquidity to ensure that it can meet its obligations and avoid financial problems with its creditors due to late payments. This is even more critical during some periods of a business’s development, particularly during a growth phase.

A company’s obligations comprise, among others:

• trade and other payables;
• current income tax;
• current portion of long-term debt;
• all current liabilities.

Assets convertible into cash are usually the items included in current assets, for example:

• trade and other receivables;
• work in progress, if applicable;
• inventories;
• etc.

Long-term assets, such as property and equipment, are usually not intended to be sold and, therefore, will likely not be converted into cash in the short term, with some exceptions.

You can measure liquidity either relatively or absolutely.

Relative liquidity

Relative liquidity is calculated based on certain financial ratios, the most common one being the working capital ratio, which is calculated in the following manner:

Current assets/current liabilities

The minimum target is a 1.20 ratio, i.e., $1.20 of current assets for every $1 in current liabilities.

The optimal target varies according to:

• industry sector;
• the business’s maturity.

You can ask your accountant to help you determine your company’s optimal working capital ratio.

There are other liquidity ratios, the relative liquidity ratio or the immediate cash flow liquidity (available assets/current liabilities), which can be useful in refining the analysis of the company’s liquidities.

Absolute liquidity

Absolute liquidity represents the balance remaining should a business decide to sell all of its current assets and reimburse all of its current liabilities.

Absolute liquidity is determined from the working capital which is calculated as:

Current assets − current liabilities

There is no minimum target for this indicator. Nevertheless, a negative absolute liquidity ratio would show that the business doesn’t have enough current assets to pay all of its current liabilities, which is not advisable.

Therefore, assets must reach a minimum level that supports the business’s strategic orientations and leaves enough leeway to cover unexpected expenses.

When you analyze liquidity, you cannot limit yourself to only one indicator. You must run the analysis of ratios in parallel with absolute liquidity and do a qualitative analysis of the components on the balance sheet.

For example, a working capital ratio of 1.5 by itself could seem acceptable, while the actual working capital could only amount to $5, which constitutes insufficient leeway. This shows how important it is for a business to have the support of specialists who can do a liquidity analysis that takes into account various determining factors.

There are several solutions to increase your organization’s liquidity. Please read our article on the topic, which details the most common solutions. Each possibility must be studied carefully in light of your business’s circumstances and objectives.

Once you have a clearer perspective on the situation, you can undertake a strategic planning exercise that will, among other things, improve your business’s efficiency. The path for a company to improve its financial performance and, therefore, increase its value indeed goes through improving its efficiency.

Finally, it is also crucial that the business perform a budget exercise. Although managers often neglect this forecasting exercise, they thus deprive themselves of an excellent tool to establish the business’s financial objectives and strategies. It is then essential to monitor financial performance on a monthly basis, which will ultimately also help you enhance your company’s position.