The main purpose of profitability analysis is to determine the profit margin and compare it to the appropriate financial data. Profitability should not be confused with return because profitability is based on some type of profit and sales of the company. Basically there are few ways to compare profit margins:
• Compare it to similar business. When profitability is compared to other companies that are doing business in the same industry group and are offering similar products or services, it may show whether profitability of the company is in normal level. Leading companies always has advantages in industry and higher profitability normally is explainable by some fundamental factors.
• Compare it to other periods of the same company. The financial results of any company do not stay the same and always are changing depending on market conditions and new products. Profitability analysis may show whether profit margin is increasing or decreasing. If profitability margin is decreasing it is a bad signal and reasons of that must be found.
• Compare it by products of the company. All large companies have many divisions and products (or services) and it is important to analyze profitability of the products separately to know which products are most profitable and deserve to be promoted additionally. Sometimes it is hard to allocate administration expenses or depreciation for every product separately, and then gross margin or EBITDA margin might be the best option for profitability analysis.
• Compare profitability by client. Such type of profitability analysis can be performed if company has only several large clients (market is highly consolidated). Such financial analysis would be especially necessary if products are adapted to each client.
Those are the main profit margins that are used for profitability analysis:
- Gross margin should be used when analysis has to ignore the effect operating and financial expenses.
- EBITDA margin is the most popular (in modern finance) universal margin that fits profitability analysis the best.
- Operating margin in many cases may be as good as EBITDA margin.
- Net profit margin is extremely popular because of its simplicity; however, net profit margin is not always the best ratio for the profitability analysis.