Company Profitability – High Sales Do Not Necessarily Mean a Good Business
In the previous article, we discussed financial liquidity — in other words, whether a company is able to meet its obligations on time.
Now we move on to another key area:
profitability.
A company may generate millions in revenue, have many customers and continuously growing sales, yet still earn very little profit. The opposite may also be true — a smaller company may generate a significantly higher return on its assets and capital.
That is why simply asking:
“How much did the company earn?”
is not enough.
A much more useful question is:
“How much did the company earn in relation to the resources it used and the sales it generated?”
This is precisely what profitability ratios help us understand.
Profit and profitability are not the same thing
Let us compare two companies.
Company A:
Revenue – PLN 100 million
Net profit – PLN 2 million
Company B:
Revenue – PLN 20 million
Net profit – PLN 1.5 million
Which company performs better?
If we look only at the absolute amount of profit — Company A.
But let us calculate how much of each company’s sales remains as profit.
Company A:
2 million / 100 million × 100% = 2%
Company B:
1.5 million / 20 million × 100% = 7.5%
Company A earned more in absolute terms.
But Company B earns significantly more from every złoty of sales.
That is what profitability shows us.
ROS – how much profit remains from sales?
One of the fundamental profitability indicators is ROS — Return on Sales.
In its simplest form:
ROS = net profit / sales revenue × 100%
Suppose:
Revenue = PLN 10 million
Net profit = PLN 500,000
ROS = 500,000 / 10,000,000 × 100% = 5%
What does 5% mean?
In very simple terms:
for every PLN 100 of sales, the company retains PLN 5 as net profit.
This is why ROS can be a very practical indicator for managers.
Example: sales are growing, but ROS is falling
Year 1:
Revenue – PLN 10 million
Net profit – PLN 800,000
ROS = 8%
Year 2:
Revenue – PLN 15 million
Net profit – PLN 900,000
ROS = 6%
At first glance, the situation looks very positive.
Sales increased by 50%, while profit increased by PLN 100,000.
However, profitability declined:
from 8% to 6%.
The company now needs to generate significantly higher sales to achieve only a slightly higher profit.
This brings us back to the question raised in the previous article on causal analysis:
Why?
Did the company lower its prices?
Did costs increase?
Did it increase sales of lower-margin products?
Did it acquire large customers by offering substantial discounts?
Sales growth does not always mean an improvement in the quality of the business.
ROS can be calculated at different levels of profit
Sales profitability does not have to be analysed only at the net profit level.
We can also examine operating profitability:
Operating profitability = EBIT / revenue × 100%
We can analyse profit before tax:
Pre-tax profitability = profit before tax / revenue × 100%
and net profitability:
Net profitability = net profit / revenue × 100%
Each level answers a slightly different question.
This allows us to identify at which stage of profit generation a problem may be occurring.
ROA – are the company’s assets really working?
Another important indicator is:
ROA — Return on Assets.
In simplified form:
ROA = net profit / average total assets × 100%
Suppose:
Company assets = PLN 20 million
Net profit = PLN 1 million
ROA = 5%
This means that every PLN 100 invested in assets generated approximately PLN 5 of net profit.
Why does this matter?
A company may own impressive assets: real estate, vehicles, machinery, warehouses or inventories.
But owning assets is not the purpose of running a business.
Assets should work and generate results.
Two companies, the same profit – different ROA
Company A:
Assets – PLN 10 million
Profit – PLN 1 million
ROA = 10%
Company B:
Assets – PLN 25 million
Profit – PLN 1 million
ROA = 4%
Both companies generated exactly the same profit.
However, Company A required significantly fewer assets to generate it.
This may indicate greater efficiency in the use of assets.
That is why comparing companies solely on the basis of their absolute profit can lead to misleading conclusions.
ROE – how much does the owners’ capital earn?
From an owner’s perspective, one particularly important indicator is:
ROE — Return on Equity.
In simplified form:
ROE = net profit / average shareholders’ equity × 100%
Suppose:
Equity = PLN 5 million
Net profit = PLN 1 million
ROE = 20%
This means that every PLN 100 of shareholders’ equity generated PLN 20 of net profit.
This gives us an entirely different perspective.
ROS asks:
How profitable are the company’s sales?
ROA asks:
How efficiently are the company’s total assets being used?
ROE asks:
What return is being generated on the owners’ capital?
Is a high ROE always good? Not necessarily
This is very important.
Suppose two companies each have PLN 10 million in assets and generate PLN 1 million in profit.
Company A finances its operations with:
PLN 8 million in equity + PLN 2 million in liabilities.
Its ROE is:
1 / 8 × 100% = 12.5%
Company B:
PLN 2 million in equity + PLN 8 million in liabilities.
Its ROE is:
1 / 2 × 100% = 50%
Looking only at ROE, Company B appears outstanding.
However, it is also significantly more indebted.
A high ROE may therefore result not only from high business efficiency but also from the use of financial leverage.
And greater financial leverage also means greater risk.
That is why ROE should never be analysed in isolation.
What about ROI?
Another frequently used concept is ROI — Return on Investment.
ROI answers a very practical question:
Is a particular investment worthwhile?
Suppose a company invests PLN 1 million in a new production line that generates an additional PLN 200,000 in annual profit.
In simple terms:
ROI = 200,000 / 1,000,000 × 100% = 20%
However, even a 20% ROI still requires interpretation.
We need to consider time, risk, the way the investment is financed and alternative uses of capital.
Do not ask only: “Are we making money?”
A much better set of questions is:
How much do we earn from our sales? — ROS
How efficiently do we use our assets? — ROA
How effectively does shareholders’ equity work? — ROE
Does a specific investment generate an adequate return? — ROI
Only when considered together do these indicators begin to provide a meaningful picture of the company.
The direction of change matters most
A ROS of 6% tells us very little without context.
If it was 3% a year ago, the situation is probably improving.
If it was 10%, we need to investigate the reasons for the decline.
If competitors achieve 3%, our 6% may look very strong.
If the industry average is 12%, the same 6% may indicate a problem.
This is why financial ratios should be analysed over time, against the company’s plan and in comparison with companies operating in a similar business environment.
Bringing the analysis together
We now have several pieces of the puzzle.
Horizontal analysis tells us: what changed?
Vertical analysis: what does the financial structure look like?
Inflation adjustment: how much of the growth is real?
Causal analysis: why did the result change?
Liquidity: can the company meet its obligations?
Profitability: how efficiently does the company turn sales, assets and capital into profit?
This is precisely why there is no single “magic” ratio that can tell us whether a company is good or bad.
A company can be profitable while experiencing liquidity problems.
It can have a high ROE while also carrying a very high level of debt.
It can rapidly increase sales while its profitability deteriorates.
It can also report higher nominal results simply because prices have increased.
Good financial analysis therefore begins not with calculating ratios, but with asking the right questions.
And one of the most important questions to ask next is:
if high profitability can result from debt, when does debt help a company grow — and when does it begin to threaten the business?
This leads us directly to the next area of analysis — debt and financial leverage
