What Is Profitability?

To simply put, It’s the ability of a business to generate sufficient cash flow from its operations on a sustainable basis so that there is enough money left to keep after paying off all expenses and obligations.

Profitability is not a snapshot in time, rather a reflection of the underlying health of a business driven by key factors such as sustained sales/growth, healthy margins, robust operating and business model, healthy operations and low-cost structure, efficient cash flow management, consistent positive cash flows, and solid financial management.

Profitability is like the iceberg. What you see above the surface is just a small portion, but the bigger and more relevant drivers of profitability are beneath the surface, hiding within revenues and expenses. If you can identify and tackle them individually and move them in the right direction; that is when you can see a real and sustainable shift in profitability.

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Broadly speaking, profitability for any business rests on five main pillars:

Revenue Growth and Margin Expansion
Expense Reduction and Cost Transformation
Smart Capital Planning and Analysis
Efficient Cash Flow Management
Financial Planning and Analysis
Let’s briefly look at each of them.

Revenue Growth and Margin Expansion

IBringing in more sales either by increasing customers or increasing the average sales per customer will drive higher revenues. This needs to be complimented with selling the right products and services that have the lowest cost, resulting in highest gross margins possible. Healthy gross margin is usually the first important variable that is critical in driving profitability. Businesses that typically have high gross margins are well positioned to have higher profitability, provided all other expenses are managed efficiently. This link from NYU Stern school of business provides interesting data on typical gross margins by industry/sector. Gross Margins by sector.

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Expense Reduction and Cost Transformation

Lower cost of goods and services will drive higher gross margins, while lower operating costs such as real estate and rent, overhead, payroll and benefits, most utility costs, building and equipment maintenance, loan/debt payments and such will drive higher operating margins. This would result in healthy operating income, which drives cash flows available to the business to drive growth and profitability. One way to permanently lower costs and raise profitability would be to employ Cost Transformation efforts.

Cost Transformation is accomplished by identifying areas of cost reduction opportunity and introducing changes to either operating process, methodology, employee behavior, labor productivity, vendor contracts, purchase agreements, and such with a goal of taking out costs from the system. By doing so, the business can permanently reduce the water level of its operating expenses and make a sustainable impact on improving profitability.

In some situations, this requires the right kind of process changes and leadership, while in others it may require some upfront capital expenditures to purchase equipment, software, or other assets that would drive costs lower by improving productivity and processing time, as well as reducing cost of goods and overhead expenses incurred in operating a business.

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Smart Capital Planning

Its very common for businesses to spend upfront capital on new equipment, physical assets, buildings, technology, and such, to drive more productivity and output from its operations and drive higher sales, or lower costs on a long-term basis by reducing labor, overhead costs or processing times. Having the right capital strategy is crucial in ensuring the investment you are making will drive profits for a long time and bring in ROI (Return on Investment) you are expecting.

Important financial metrics such as NPV (Net Present Value), and IRR (Internal Rate of Return) of your investment or project could help you make the right investment decision, reduce uncertainty, and ensure that the upfront capital expenditure is put to good use and drives profitability.

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Efficient Cash Flow Management

Cash flow is the life blood of small businesses, so making sure that there is enough cash on hand to run day-to-day operations, pay vendors on time, buy material, hire labor when needed, and being able to purchase and rent equipment when required, is of utmost importance. Without this ability, a business will be hamstrung in its ability to stay afloat and grow. Having healthy operating cash flow margins and sufficient working capital, as well as positive cash conversion cycle will go a long way in ensuring and maintaining profitability.

Financial Planning and Analysis

Financial planning tools such as budgeting and forecasting will allow a business to have a financial game plan, as well as set specific objectives and goals that need to be achieved from business operations. This gives businesses the ability to measure and track performance, make adjustments if necessary, and stay on course towards its profitability goals.

By having a financial planning process in place, the business owners can be better prepared to navigate changes ahead, and handle uncertainty and risk. This process is not only a risk management tool, but also helps in making changes to the business/operations to take advantage of changing market conditions, i.e., increase sales and revenues by making pricing changes due to higher demand, cutting costs by negotiating with vendors, and investing in growth due to positive economic outlook, all of which at the end of the day improves profitability.

PROFITABILITY ANALYSIS

In a simple world, if you make more than you spend, most people think of that as profit. But in a business, there are a lot more variables involved that determine profitability. To gain a thorough understanding of all such variables, we must dig down deeper into the financial statements and do both vertical and horizontal analysis of major drivers identified above, as well as derive financial metrics such as gross margin, gross profit, operating profit, net income, return on assets (ROA), return on investment (ROI), and return on equity (ROE), to gauge the overall health and profitability of a business.