Article
Profitability analysis: ROS, ROE and ROA are not enough, you need segment accounts
Profitability ratios from the P&L tell you how much the company earns on average. They do not tell you which client, product or department earns and which one eats the others’ profit. Using the model company I show both levels: company-wide ratios with a DuPont breakdown, and a contribution-margin account for three segments.
Author: Tomasz FordymackiPublished:
Level one: ROS, ROA, ROE and the DuPont breakdown
| Ratio | Formula | Model company | Sector |
|---|---|---|---|
| ROS (net margin) | net profit ÷ revenue | 6,0 % | 4,2 % |
| Asset turnover | revenue ÷ assets | 1,52 | 1,55 |
| ROA | ROS × asset turnover | 9,1 % | 5,5 % |
| Leverage | assets ÷ equity | 2,45 | n/a |
| ROE | ROA × leverage | 22,4 % | 14,0 % |
An ROE of 22.4 % looks excellent, but the breakdown shows where it comes from: a margin above the sector, not turnover (1.52 against 1.55), and largely leverage. Assets are almost two and a half times equity because liabilities finance the growth. Such a company earns well, but the same result with faster collection would need less capital and give a higher ROA.
Level two: segment accounts
| PLN m | Segment A | Segment B | Segment C | Total |
|---|---|---|---|---|
| Revenue | 14,0 | 11,2 | 6,4 | 31,6 |
| Contribution margin I | 4,2 | 2,8 | 1,3 | 8,3 |
| as % of revenue | 30 % | 25 % | 20 % | 26 % |
| Segment fixed costs | 1,4 | 1,2 | 1,6 | 4,2 |
| Contribution margin II | 2,8 | 1,6 | −0,3 | 4,1 |
| Shared costs | – | – | – | 0,7 |
| EBITDA | – | – | – | 3,4 |
At company level everything adds up: EBITDA PLN 3.4m, a 10.8 % margin. The segment account shows that segment C does not even cover its own fixed costs: its second-level margin is minus 0.3m. Segments A and B earn 4.4m, of which 0.3m funds C’s loss. Shared costs (management, accounting, office) stay below the line because they will not disappear if any segment is closed: spreading them as an “overhead” would make B look loss-making and suggest the wrong decision.
What to do with a segment below zero
- Check which of the segment’s fixed costs would really disappear if it closed. If half of the 1.6m is people you would move to A, the saving is smaller than the loss.
- Compute the segment’s break-even: with a 20 % first-level margin, segment C needs PLN 8.0m of revenue to cover its 1.6m of fixed costs. It is 1.6m of sales short.
- Check prices and terms: the segment with the lowest margin often also has the longest payment terms, so it costs twice, in profit and in cash.
- Only at the end consider winding it down, with a plan for the costs that will remain.
Service: profitability analysis of the company, clients and projects
Frequently asked questions
What are a company’s profitability ratios?
The basic ones are EBITDA margin, ROS (net margin), ROA (return on assets) and ROE (return on equity). Management analysis adds first- and second-level contribution margin for segments: clients, products, departments or projects.
What is contribution margin?
First-level contribution margin is revenue minus variable costs: what remains to cover fixed costs and profit. The second level also subtracts fixed costs attributable directly to the segment (its people, equipment, marketing). Company-wide shared costs are subtracted only at the total level.
How often should profitability be analysed?
Company-wide ratios once a quarter are enough. Segment accounts are best monthly in the management report, because changes in prices, exchange rates and client mix move a segment’s margin faster than the annual accounts show.
Let’s talk about your situation
Write a few sentences about the company and the problem. I reply within one working day and the first conversation is free.
Write to me