Company profits – the good, the bad and the ugly

By: Tim Bennett

Company profits – the good, the bad and the ugly

When it comes to reporting results, companies can sometimes be a little disingenuous. That’s because the directors want shareholders to take away a positive story of growth, whether in sales, assets, cash flow, or all three. Shareholders, on the other hand, want reliable numbers that can be trusted to reveal how well the firm is doing. So, which numbers can you trust?

The good guys

Whilst there are many ways to report a profit, two numbers are better than most;
To find them, you need to do a little bit of digging around in a profit and loss account. We’ll take each one in turn.

Gross profit

This is the firm’s profits once direct cost of sales have been deducted from sales.
As a reported numbers it has several benefits – it is easy to calculate, hard to manipulate and it is trusted by names such as Terry Smith, CEO of Fundsmith.
Operating profit

This number looks at profitability after direct cost of sales and overheads, but before financing costs (interest) and taxes.
For many investors, this is a critical number as it reflects the profitability of the core activities of the business after all the direct and indirect costs associated with running it.
So far, so good. Now for some less reliable but nonetheless popular profit numbers.

A popular flatterer - EBITDA

This one requires a bit more homework as you won’t find it stated directly in the profit and loss account. Earnings before interest, tax, depreciation and amortisation works like this;
In short, you adjust operating profit by adding back any depreciation or amortisation that was taken away to arrive at it. The logic is that these represent arbitrary accounting charges for the cost of wearing out long-term assets and as such they can distort profits.
The problem with EBITDA is it can be easily abused. Once you ignore capital costs (depreciation and amortisation) and interest a firm of directors may be tempted to load up on debt and go on a spending spree, knowing that any mistakes will not be fully reflected in earnings calculated this way. That said, there are worse profit numbers out there.

The ugly gang – “special” profit numbers

Be very wary of firms that choose to report their own profit figures in an attempt to fool you into ignoring the ones they are supposed to disclose by law. Usually these “special” numbers exclude inconvenient costs and try to paint a picture that suits the directors. Some examples are given below.
The conclusion? Non-statutory profit numbers are often evidence that the directors are having to work too hard to flatter investors. Whilst the legally required numbers may not be perfect, they are usually more reliable. If in doubt, be cynical about overt attempts to distract you from them.