There is one simple rule to decompose and analyze profitability sources of a business. Parés Method distinguishes three main components for profitability of an enterprise: Rotation, Profit and Financial Leverage.

The profitability of an establishment can be explained as the result of considering three key ratios in every business operative and management.

Profitability = Rotation * Profit * Leverage

Rotation refers to the relationship between a fixed asset and the amount of turnover or sales it generates. Thus if the asset "rotates" more, or means a smaller portion of sales figures, we’re most likely to achieve a greater profitability. A classic example may be the case of a hotel room. This asset, the more is used or sold, will have more chances to generate benefits for the owner.

Profit is the difference between a product’s cost price and the selling price. This will adhere to specific particularities of the product such as demand pressures, supply constraints, uniqueness, creativity, differentiation, and many more. In short, a higher profit is more likely to produce benefits.

Financial Leverage means that if a company achieves a profit for its normal development, and in percentage this represents higher levels than the market’s financing cost, recurring to such financing there would be a jump in its profitability as a result of using foreign capital, not their own. A simple example is that when a company achieves returns of 15% based on their own activity, still above the 5% external finance cost average, using credit, the ratio between profit and equity capital increases, and Thus, the profitability of the business.

With these three assumptions very clear, it is possible to analyze the profitability and performance of a large number of businesses, and in turn, can be compared both profitability between companies, as the sources of profitability of each one of them.

In turn, these three ratios help us to distinguish between growth strategies of different companies whose behavior we could categorize, depending on the performance of each indicator, and its joint result; as balanced, fast, stagnant or risky.

C4T offers services of Asset Management that incorporate an assessment of the current situation, detailed action and improvements plans, and monitor the key business variables. Accompany the process of optimization is vital to the success of the project.

In turn, in some cases further analysis is appropriate as well as carring out an operational audit of Departments or Business Areas, so as to identify the causes of its evolution and propose corrective actions.

If you want to explore some of these concepts or consult about a specific situation, do not hesitate to contact us.


Pablo Urani - C4T