CLO-3 ASSIGNMENT

CHEMICAL ENGINEERING ECONOMICS

2016-CH-454
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Profitability

Profitability is ability of a company to use its resources to generate revenues in excess of

its expenses. In other words, this is a company’s capability of generating profits from its
operations.

Profitability

Profitability is one of four building blocks for analyzing financial statements and company
performance as a whole. The other three are efficiency, solvency, and market prospects.
Investors, creditors, and managers use these key concepts to analyze how well a
company is doing and the future potential it could have if operations were managed
properly.
The two key aspects of profitability are revenues and expenses. Revenues are the
business income. This is the amount of money earned from customers by selling products
or providing services. Generating income isn’t free, however. Businesses must use their
resources in order to produce these products and provide these services.

Four ways to measure profitability

 Margin or profitability ratios:

Perhaps the best way to determine whether you run a profitable business is by running
margin ratios, also referred to commonly as profitability ratios. To run these figures, you’ll
first need to calculate three things from your income statement:

1. Gross Profit = Net Sales – Cost of Goods Sold

2. Operating Profit = Gross Profit – (Operating Costs, Including Selling and Administrative
Expenses)
3. Net Profit = (Operating Profit + Any Other Income) – (Additional Expenses) – (Taxes)
All three of these figures provide you with a way to express profit from a dollar perspective.
We can take this a step further by turning these figures into ratios. Doing so is beneficial
because it allows you to analyze your company more accurately. Ratios help you
measure efficiency much better than straight dollar amounts.
For instance, in Q1, you may have a higher gross profit margin than in Q4, even though
you earned more money (from a dollar amount perspective) in Q4. Additionally, ratios
allow you to compare your company to others in your industry.
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Just because a company earns more profit doesn’t mean it’s financially healthy. Margin
ratios are a far better predictor of health and long-term growth than mere dollar figures.
Below, we’ll look at how you can turn things like gross and net profit into ratios so that
you can better analyze your company’s financial health. One ratio is not better than the
other. All three will help give you an accurate look at the inner-workings of your business.

 Gross profit margin ratio:

If you sell physical products, gross margin allows you to hone in on your product
profitability. Your total gross profit is sales revenue minus your cost of goods sold. Cost
of goods sold represents how much your company paid to sell products during a given
period.
In other words, it’s profit after deducting direct materials, direct labor, inventory, and
product overhead. It does not consider your general business expenses. The formula to
calculate the gross profit margin ratio is:
Gross Profit Margin Ratio = (Gross Profit ÷ Sales) × 100
If the gross profit margin is high, it means that you get to keep a lot of profit relative to the cost of
your product. One of the primary things you want to concern yourself with is the stability of this
ratio.
Your gross margins shouldn’t fluctuate drastically from one period to the other. The only thing that
should cause a severe fluctuation would be if the industry that you’re part of experiences a
widespread change that directly impacts your pricing policies or cost of goods sold.

 Operating profit margin ratio:

The operating margin provides you with a good look at your current earning power. Unlike
gross profit, which you would prefer to be stable, an increase in the operating profit margin
illustrates a healthy company. The formula to calculate the operating margin is:

Operating Profit Margin Ratio = (Operating Income ÷ Sales) × 100

The operating margin gives you a good look at how efficient you are. If you’re looking to
compare your returns to others in the industry, this is the best ratio to do so, as it shows
your ability to turn sales into pre-tax profits. Many individuals in corporate finance find this
to be a much more objective evaluation tool than the net profit margin ratio.
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One of the things that can keep this ratio stagnant is an increase in operating expenses.
If you suspect that some operating costs are creeping up, you should perform a
comparative analysis of your operating expenses.
A comparative analysis is a side-by-side percentage comparison of two or more years of
data. It’s a little more time-consuming than a basic ratio calculation, but it’s not too bad if
you can export the data from your accounting software.

 Net profit margin ratio:

Net profit margin, sometimes referred to as just “profit margin,” is the big-picture view of
your profitability. Some industries — like financial services, pharmaceuticals, medical,
and real estate — have sky-high profit margins, while others are more conservative.
Use industry standards as a benchmark, and perform an internal year-over-year
comparison to assess your performance. The formula to calculate the net profit margin
ratio is:

Net Profit Margin Ratio = (Net Income ÷ Sales) × 100

Net profit margin is similar to operating profit margin, except it accounts for earnings after
taxes. It demonstrates how much profit you can extract from your total sales.

Break-even analysis:
Your break-even point is the point at which expenses and revenues are the same. You’re
not making money at your break-even point, but you’re not losing money either. You
should take time to measure your break-even point to determine how much “breathing
room” you have in case things turn south.
You can calculate the break-even point for various components of the business. For
instance, you can measure the break-even point as a figure of sales. The formula to do
so is:

Break-Even Point Sales = Fixed Expenses + Variable Expenses

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You could also measure your break-even point against units sold. The method to do so
is:

Break-Even Point for Units Sold = Fixed Expenses ÷ (Unit Sales Price – Unit
Variable Expenses)
Running these figures allows you to determine how profitable you’ll remain in the future
were something to happen to your company.

Return on assets and return on investments:

The last two measures of profitability that you can get from your financial statements are
return on assets (ROA) and return on investments (ROI). ROA shows total revenue
compared to total assets used. You can use this figure as a comparison tool from period
to period within your company and with other firms in your industry. The higher the ROA,
the more efficiently you operate. The formula to calculate ROA is:

Return on Assets = (Net Income Before Taxes ÷ Total Assets) × 100

ROI shows how much you’re earning compared to the investments that you make.
Measuring profitable investments allow you to ensure that you’re putting your money in
the right places.
You want to make sure that your ROI is at least as high as what you’d be earning in a
risk-free investment, like a high-yield savings account or CD. If it’s not, you’d be better off
putting your money into one of these accounts, as they would yield higher earnings. ROI
is basically a measure of whether “this is all worth it.” The formula to calculate ROI is:

Return on Investment = Net Profit Before Tax ÷ Net Worth

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Balance Sheet
A balance sheet is a financial statement that reports a company's assets, liabilities and
shareholders' equity at a specific point in time, and provides a basis for computing rates
of return and evaluating its capital structure. It is a financial statement that provides a
snapshot of what a company owns and owes, as well as the amount invested by
shareholders.

It is used alongside other important financial statements such as the income statement
and statement of cash flows in conducting fundamental analysis or calculating financial
ratios.

Formula Used for a Balance Sheet:

The balance sheet adheres to the following accounting equation, where assets
on one side, and liabilities plus shareholders' equity on the other, balance out:

Assets=Liabilities+Shareholders’ Equity
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This formula is intuitive: a company has to pay for all the things it owns (assets) by either
borrowing money (taking on liabilities) or taking it from investors (issuing shareholders'
equity).

For example, if a company takes out a five-year, $4,000 loan from a bank, its assets
(specifically, the cash account) will increase by $4,000. Its liabilities (specifically, the long-
term debt account) will also increase by $4,000, balancing the two sides of the equation.
If the company takes $8,000 from investors, its assets will increase by that amount, as
will its shareholders' equity. All revenues the company generates in excess of its liabilities
will go into the shareholders' equity account, representing the net assets held by the
owners. These revenues will be balanced on the assets side, appearing as cash,
investments, inventory, or some other asset.

Limitations of Balance Sheets:

The balance sheet is an invaluable piece of information for investors and analysts;
however, it does have some drawbacks. Since it is just a snapshot in time, it can only use
the difference between this point in time and another single point in time in the past.
Because it is static, many financial ratios draw on data included in both the balance sheet
and the more dynamic income statement and statement of cash flows to paint a fuller
picture of what's going on with a company's business.

Income Statement
An income statement is one of the three important financial statements used for reporting a
company's financial performance over a specific accounting period, with the other two key
statements being the balance sheet and the statement of cash flows. Also known as the profit and
loss statement or the statement of revenue and expense, the income statement primarily focuses on
the company’s revenues and expenses during a particular period.

Income Statement Structure

Mathematically, the Net Income is calculated based on the following
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Net Income = (Revenue + Gains) – (Expenses + Losses).

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