How to evaluate a company’s potential profitability?
Many techniques can be used to evaluate a company’s potential profitability and financial condition.
Projected Statements: By projecting a company’s financial statements under varying assumed conditions,you can learn the effects of the risks of the assumed conditions — economic slowdowns, strikes, heavy promotion efforts, or other variables that affect the company’s operations. The results, however, are only as reliable as the underlying assumptions.
Break-even Analysis: If a company’s fixed and variable costs are known, it is possible to calculate the revenue volume needed to “break even.” More important, given certain projected revenue volumes, it is possible to calculate the expected profit at these levels.
The break-even sales figure is the sales volume at which the contribution to fixed costs equals the fixed costs. Fixed costs are expenses that do not vary with sales. The company would have incurred these costs even if it did not open its doors. The contribution to fixed costs is the percentage of a sales dollar that is not used in out-of-pocket costs to produce the item and make the sale (these costs are commonly called the variable costs).
The break-even sales level is thus calculated by dividing the fixed costs by the contribution percentage:
Break-Even Sales = Fixed Costs x (Sales – Variable Costs) / Sales
For instance, if variable costs are 40 percent of a dollar of sales and the company’s fixed costs are $30,000, the company must sell $50,000 ($30,000 / 0.6) to break even. At $50,000 sales, the variable costs are 40 percent, $20,000, leaving $30,000 to cover the fixed costs.
Profit at any sales level can be calculated simply by multiplying the sales projection by the contribution margin and subtracting the fixed costs. This is a straight-line relationship, so it can be charted for convenient reference. It is important to reemphasize that profit is different from cash. An enterprise in its growth stage can be profitable and still run a major cash deficit.