A guide to profitability analysis for startups

Profitability analysis may not be the most exciting part of starting your new business, but it’s absolutely crucial. 

And it doesn’t have to be a hassle. In any business sector, measuring your profitability is just a matter of tracking key financial metrics, such as your return on investment, net profit margin, and more.

If you’re feeling overwhelmed by your profitability analysis, read on. This guide will walk you through the key metrics, benefits, and tools you need to know to analyze your business’s profitability.

What is a profitability analysis?

Profitability analysis is a process that will help you determine your startup’s ability to generate profit. In simpler terms, this data will tell you how profitable your business will be. An accurate profitability analysis can help you troubleshoot and optimize your business plan, setting you up for stable, long-term growth.

A profitability analysis can be conducted by a financial professional like a managerial or financial accountant. Business owners can also conduct their own profitability analysis with the right accounting tools like expense tracking software and record management software.

As a startup owner or manager, profitability analysis is one of the most important tools in your toolbelt. It will give you an overview of your business and let you identify problems. It can also be the key to demonstrating your startup’s potential to investors.

Key metrics for determining the profitability of your startup

The first step in a successful profitability analysis is understanding your key metrics. Return on investment (ROI) is one of the most commonly used metrics. Other key metrics, or profitability ratios, that can provide an accurate picture of your profitability include:

• Gross Profit Margin
• Net Profit Margin
• Operating Profit Margins
• Return on Equity (ROE)
• Break-Even Point
• Customer Lifetime Value (CLV)
• Customer Acquisition Cost (CAC)

You can also look into financial ratios to help measure your profitability. A debt-to-equity ratio, for example, will measure your shareholders’ equity as your business grows. Every detail matters — a full profitability analysis should analyze every metric to provide the clearest possible picture.

Benefits of conducting a profitability analysis

Profitability analysis is important for businesses at all stages. But it’s particularly crucial for a startup. That’s because it can help you identify issues, plan for future challenges, and maximize your startup's financial growth.

Below are a few more benefits of conducting a thorough profitability analysis for your startup.

Enhanced financial decision-making

A profitability analysis will set you up for smart, informed decision-making. With a clear picture of your current financial health, you can look into changes that will benefit your startup in the long run.

According to Tom Eisen, author of Why Startups Fail, one of the main challenges new startups face is uninformed decision-making from stakeholders. With so many stakeholders involved in a startup — founders, employees, partners, and investors — it’s crucial that everyone is on the same page. A profitability analysis provides the information needed for unified financial decision-making.

Identifying profitable products/services

Key measures of profitability, like your cash flow margin, percentage of sales, and return ratios, will help you identify products that will bring in the most cash. In other words, a profitability analysis shows you which products you should lean into.

For example, consider a clothing brand that markets a line of hats. The brand’s profitability analysis shows that bucket hats have a low average cost to produce and a high cash return, thanks to current trends. In that case, the business might want to invest in a new line of bucket hats.

Evaluating business model effectiveness

A profitability analysis can help you target problems within your business model. It will show which departments have the highest operating costs and where you should allocate resources. For example, an analysis of your customer lifetime value (CLV) and customer acquisition cost (CAC) can show you whether it’s more profitable to retain or acquire customers so that you can adjust your business model accordingly.

Tools and methods for calculating profitability

There is more than one way to conduct a thorough profitability analysis. Depending on your industry, startup costs, stakeholders, and other factors, the right tools to measure your business’s profitability can vary. Here are a few components financial experts use to conduct a financial analysis.

Financial statements (income statements, balance sheets, cash flow statements)

Your profitability analysis will most likely start with a financial statement analysis. Key statements that contribute to your overall outlook include:

• Income statements: An income statement outlines projected revenues and expenses.
• Balance sheets: Another important component of most profitability analyses, a balance sheet includes metrics like your return on assets and return on equity.
• Cash flow statements: A cash flow statement demonstrates the liquidity of your company and can be a helpful tool for financial decision-making.

Businesses in all industries will benefit from a financial statement analysis, especially in the startup phase. It isn’t the only component of a full profitability analysis, but it’s an important building block and should become standard practice as your business grows.

Contribution margin analysis

A contribution margin analysis can help inform your decision-making by showing which products or services are most profitable. It subtracts variable costs from revenues to help business owners allocate their resources and decide which products, departments, or services should be funded and which should be cut. This tool will be most helpful for businesses in the retail or services industry but can be a component of any profitability analysis.

Activity-based costing (ABC)

Activity-based costing helps you determine production costs. It looks into the direct cost of activities like testing a product or packaging to help you streamline production. ABC is most beneficial for product-based businesses.

Demonstrate profitability with the right accounting software

A thorough, detailed profitability analysis is a crucial early step in your startup's managerial accounting. It will help you spot potential issues, streamline your financial planning, and make informed decisions as your business grows.

You could hire a professional accountant or financial analyst to conduct your profitability analysis. 

Or, with the right accounting software, you can look into your business’s profitability yourself. Digital financial tools are a more affordable solution that can help you handle your analyses, statements, records management, and more.