This is the first article in a four-part series on how to measure company profitability. Parts one, two, and three can be found here:
How to Measure Profitability, Part 2 - Defining profitability ratios.
(coming soon) How to Measure Profitability, Part 3 - comparing profitability of two companies.
How to Measure Profitability, Part 4 - Border Group Inc profitability just before bankruptcy.
Reading a news article or watching someone say on television “…fourth quarter profit margins were up 23%..” does not have much meaning as snippets of data like this have no context. A company may be profitable, but may also be in poor overall financial health.
“Up 23%” from what…negative 50%?
In this three part series, we explain what profitability is, discuss why it is important, and go through two separate examples using actual company data. We first compare the profitability of two anonymous companies, but we will give you a hint. They both sell microchips. With a little research and intel-gathering on your own, you might be able to figure out which companies we chose to analyze that sell these advanced and highly sophisticated microcomputer devices.
We then go through a second example. We revisit the Borders Group Inc, a bookseller that went bankrupt in 2011. In our How to Measure Liquidity article series, we used their company data for our liquidity example, and we will once again use this financial data for our Borders profitability example.
A basic explanation of profitability
In a financial sense, the term Profitability describes the financial health of an organization. Profitability can be interpreted several ways, but profitability can generally be described as how well a company can get a return on the investments they make. If a company is bringing in more revenue than it costs to create those revenues, then a company can be called profitable. This means that after all is said and done – the checks are cashed, the workers are paid, the bills are sent, the government has their taxes, that hopefully there is a positive number in the company’s bank account and certainly on their financial statements.
The value left over after producing something and selling it is profit. The ability of a company to produce profit is their profitability.
Why look at company profitability?
Profitability can also be labeled as a measurement of business success. So, you could roughly say success = profitability. If you are the owner, employee, stockholder, or a person who at least has some interest in the success of the company, then you need to be thinking profitability. A company can do many things wrong, but if it is still profitable, then many other missteps along the way are often forgiven.
What about negative profitability? A company can certainly lose money, where every item they sell or service they provide costs the company more than they could sell it. You can expect you will be faced with negative profit values if you research enough companies.
If you have a stake in the company’s success, then you certainly want to measure profitability. The best thing about measuring is that once something can be measured, it can be improved.
You need to approach a profitability analysis from several angles to get some sense of relevance and relation of the results compared to the rest of the company’s operating values. Some companies operate on razor-thin profit margins, where they may bounce between negative and positive margins regularly or cyclical, as in seasons or in conjunction with holidays.
In our next article in our How to Measure Profitability series, we explain what tools we use to calculate, measure, and give meaning to company profitability.
Proceed to: How to Measure Profitability, Part 2 - Defining profitability ratios.
Odd arrow road sign photo used under Creative Commons by Oatsy.