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  • Profits are to business what was smiley is in text messaging.

  • When a company tells us in one of its regular announcements that it's making good profits, we assume it's doing well.

  • Unfortunately, it may not be that simple.

  • The company may be pulling the wool over our eyes.

  • It may even be about to go belly up.

  • Most people think that profits are what a company has left over after meeting its expenses.

  • For a can of fizzy drink, this would be the retail price minus the cost of buying it at wholesale, and less any overheads, such as paying staff.

  • Thank you.

  • Profits come in different varieties just like fizzy drinks.

  • But sometimes they can leave investors feeling decidedly flat.

  • Understanding why companies emphasize different measures at different times gives us clues as to what they're really thinking.

  • Profits before tax is the measure often quoted by FT journalists.

  • Sometimes to the irritation of big companies.

  • A simple definition is sales minus operating costs and interest payments, plus a share of returns from partner companies.

  • Operating profits are seen as an even more straightforward measure.

  • On the face of it, these are nothing more than sales minus operating costs.

  • But even this is a little more complicated.

  • First, sales may include money that the company hasn't received yet.

  • Second, businesses have to deduct something for assets that are wearing out, like machinery, even if there's no cash cost.

  • As a result, companies and investors prefer a measure with a dreadful acronym.

  • This is Ebitda, which stands for earnings before interest, tax, depreciation and amortization.

  • Businesses also make up their own definitions of profits.

  • The more convoluted these are, the less reliable they tend to be.

  • Usually someone is trying to hide something.

  • A company with simple operation that's doing well, is more likely to highlight a statutory measure like profits before tax than a rival that's doing badly.

  • No discussion of profits and losses will be complete without a mention of kitchen sinking.

  • When a new boss comes in to run a large corporation and clear up a mess left by the previous one, they may write off the value of assets such as liabilities and subsidiaries by quite large amounts.

  • They may include everything up to, and including, the kitchen sink.

  • Those write downs might have no cash cost, but the shares might fall anyway.

  • They then have scope to rebound more steeply if profits recovered, assisted perhaps by write backs of value.

  • The write backs in turn could boost the bonus of the chief executive.

  • Accountants don't have many zingers, so it's worth quoting one of their few snappy lines: "Sales are vanity, profits are sanity, but cash is reality."

  • It's meant to discourage companies going hell for leather for sales.

  • The message is that bosses should prioritize cash receipts over profits too, which as we've seen can be pretty unreliable.

  • Jonathan Gutherie, Financial Times, London.

Profits are to business what was smiley is in text messaging.

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Profits explained | Finance Decoded

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    Kristi Yang posted on 2021/07/30
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