A way for businesses and companies to better evaluate their performance
Underlying profit is a way for businesses and companies to better evaluate their performance. Typically done internally, the intention is to get a more accurate understanding of profits and earnings.
The standard accounting method is net profit, a calculation that is listed on mandatory documents such as financial statements. It differs from net profit as it is not reported on the mandatory, regulated documents.
This differing profit calculation method typically excludes one-time charges or infrequent occurrences and instead focuses more on recurring costs during the accounting cycle.
Additionally, its calculations in most years typically rest on a company's EBITDA, meaning that it does not consider taxes, depreciation, or amortization and mostly focuses on the business's earnings before those losses.
Focusing on recurring costs during the accounting cycle and excluding one-time or infrequent costs allows businesses to understand their future stability and identify costs that need to be cut out. Underlying earnings can help business management forecast reasonable statistics.
Alternative profit calculations may sometimes be mentioned or brought to light during annual reports. A subtotal of these different profit calculation methods is also often reported on the face of the income statement.
No company has the same underlying profit calculation method. It varies on how the business operates and what it believes should or should not be added. The unique aspect of it is why many believe it is often more accurate than statutory profit calculation methods.
It should be noted that underlying profits do not mean much unless compared with standard profit accounting methods. Simply seeing them on their own would provide less benefit to investors and business managers than seeing them alongside standard profit calculations.
How is the Underlying Profit Calculated?
Every business calculates its profits. The profits published in financial statements are produced by subtracting all dollar costs from the revenue they generated. The GAAP (generally accepted accounting practices) requires this from every company.
Given that there is no set metric or standard form of calculating it, how do companies do it? A common theme across industries is to begin by removing non-recurring costs from the equation.
Examples of common non-recurring costs for businesses include:
Natural disaster damages
Abnormal legal costs
Asset impairment charges
Changes in accounting policies
By reducing the costs from singular or rare events that are unlikely to occur again, investors can better understand company practices and profits. Underlying profits are also essential for companies when making general business plans.
Business managers formulating a business plan or estimating future revenue must remove one-off costs in order to get an accurate picture of the future of the company. There is, however, a second item that should be removed in order to complete the calculation.
It is important to remember that in order to calculate underlying profits, businesses also have to exclude one-time or non-recurring revenue gains. The most common way companies experience a one-time gain is through asset sales.
Example of Calculating Underlying Profit
An example of an agricultural business can help visualize how companies determine this alternative profit.
A farmer grows crops on 100 acres but only 80 of those acres are actually producing crops to be sold. The farmer can sell the other 20 for a one-off revenue gain. When the farmer calculates standard profit, the revenue from the sale would be included.
If a fire damages the machinery, the farmer would need to purchase the same machine equipment once more. The farmer must include the costs of buying more machinery in the standard profit calculations.
On the other hand, when calculating it, the farmer would not include one-off revenue gain from selling land nor the one-off expense of buying more machinery. This gives the farmer a more precise understanding of the consistent revenues and expenses of the farm.
If the farmer would not look at underlying profit and only at the standard profit accounting method, it would be difficult to understand how the business makes or loses money every accounting cycle. This would impair business decisions on how to increase revenue.
Advantages and Disadvantages
The advantages of underlying are significant, specifically with two key entities that interact with a company.
Here are the key advantages of relying on its calculations:
It allows managers to create strong business plans to help a company grow. Without this, companies can lose direction and fail.
Investors also benefit from this alternative profit calculation as it indicates how much money a company is generating through its standard business operations. Without this, investing in any business would be riskier.
Both of these are based on the idea that removing one-off expenses or revenue gains displays more accurate profits, giving a clearer picture of year-to-year earnings. This leads to the disadvantages of alternative profit calculations.
While calculating underlying profits can clarify how a business generates revenue or incurs costs regularly, it can also create confusion. This double-sided nature of understanding alternative profits means that investors need to be wary of what is possible.
Here are the key disadvantages of relying on underlying profit calculations:
Any confusion from alternative profit methods stems from the fact that they have been calculated in individual, unique ways.
Additionally, alternative profit calculator methods have, at times, been used to deceive investors. Given that there are no regulations around how businesses prepare these profits, they can, at times, hide expenses or inflate revenue.
Detriments caused by underlying profits are especially strong when they also make it difficult for investors to understand GAAP standard profits. In some cases, firms have excluded data that have had negative impacts over several quarters.
Insight From Deloitte
Deloitte is the largest professional services network in terms of revenue and number of professionals across the world. Additionally, it is considered to be one of the Big Four accounting firms alongside PricewaterhouseCoopers, KPMG, and EY.
As an international corporation, they are capable of surveying the top companies and CEOs on how they analyze and utilize underlying profits. In a 2011 financial survey titled "Underlying Performance - Underlying Profits," Deloitte surveyed CEOs on alternative profit calculations.
Many questions centered on how alternative profit calculations should be presented to investors.
According to Deloitte, "Non-GAAP financial information should not be presented with undue prominence, emphasis or authority." Underlying profits are considered non-GAAP financial information. They should therefore be less relied upon than traditional profit calculations.
Deloitte continues by saying, "When preparing and presenting financial information, directors should exercise judgment when determining the appropriate level of prominence given to any non-GAAP financial information."
The fact that it is a source of non-GAAP financial information is a clear disadvantage. It reiterates that alternative profit calculation should not be considered alone and should always be analyzed alongside standard profit calculating methods.
It is a unique way that companies calculate profits typically to get a stronger understanding of cyclical revenues and expenses. This is because of its emphasis on removing one-off or individual costs and gains during the accounting cycle.
It is essential to keep in mind that alternative profit calculations are not consistent across companies or industries. Different businesses get to choose which gains or costs they remove in their alternative profit calculation.
While essential for both business managers and investors, it cannot be solely relied upon. As a non-GAAP form of financial information, underlying or alternative profit calculations and conclusions must always be contrasted with standard profit calculations.
Whether you are a business manager or an investor, being able to understand an alternative profit calculation or do one yourself, is an important financial skill.
WSO provides its members with a Financial Statement Overview course to master the necessary skills in reviewing and understanding financial statements.
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Researched and authored by Adrian de Vernou | LinkedIn
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