Underlying earnings the figure excluding any one-off items such as the sale of land that is not part of the company's normal business.
- Underlying EBIT margin is profit from operations, excluding the effect of exceptional items before taxation and excluding third party production, divided by revenue from production.
- Underlying EBITDAR represents underlying earnings before income tax expense, depreciation, amortisation, non-cancellable aircraft operating lease rentals and net finance costs.
Profits and Profit Maximization
As profits play a significant role in the firm's ability to provide dividends, attract capital, maintain growth, engage in research and development, provide good service to its customers, and possibly even survive, we will make the assumption that its main goal is to make as much profit as possible. Other related and competing objectives will fall into their proper place after we examine the basic theoretical construct underlying profit maximization. The profit maximization assumption seems intuitively reasonable and analytically productive.
Impact of Underlying Profit
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) helps measure the company's underlying profit, banks and other sources of capital tend to use EBITDA when determining how much money they can lend. These institutions measure that amount in turns; one turn is equal to the business's EBITDA. For example, if the business is generating $3 million in EBITDA, one turn of EBITDA is $3 million. If a company is being sold for $15 million, the Buyer needs to come up with five turns of EBITDA.
Examples of Underlying Profit
- Underlying Profit can be calculated by taking a company's operating profit and adjusting it for any one-off, non-recurring items such as restructuring costs, asset write-downs, and legal settlements. For example, if a company had an operating profit of $1 million and $500,000 in restructuring costs, its underlying profit would be $500,000.
- Another example is when a company has an operating profit of $2 million and $300,000 in legal settlements. In this case, the company's underlying profit would be $1.7 million.
- A third example is when a company has an operating profit of $3 million and $400,000 in asset write-downs. In this case, the company's underlying profit would be $2.6 million.
Advantages of Underlying Profit
Underlying Profit is operating profit adjusted for exceptional items like restructuring costs. It offers a number of advantages, including:
- It allows for better comparison of performance between different companies or different periods of time since it strips out one-off or unusual items. This helps investors to better assess the performance of a company.
- It can help companies to understand the true profitability of their operations and to identify areas of the business where costs can be better managed.
- It can also provide a more realistic picture of a company's performance than reported profit, which may be distorted by one-off items.
- Underlying profit can also be used to assess a company's performance versus that of its peers and competitors.
Limitations of Underlying Profit
Underlying profit is an important measure of a business's performance and is used for comparison purposes. However, there are a few limitations to consider when using this metric:
- The calculation of underlying profit can be subjective and vary from company to company. Depending on the method of calculation, differences in accounting practices and the type of items excluded from the calculation can produce different results.
- Underlying profit may not take into account some non-recurring items that could affect the company's financial performance. For example, a company may have one-time transaction fees that are not included in the calculation of underlying profit.
- Underlying profit may also be used to mask underlying issues within the company. Companies may try to make their performance look better than it actually is by excluding certain items from their calculation.
- Finally, underlying profit does not take into account factors such as depreciation, amortization, and other non-cash expenses which might have a significant impact on a company's financial performance.
Introduction In addition to Underlying Profit, there are several other approaches used to evaluate a company's performance. These include:
- Operating Profit Margin which calculates the ratio between a company’s operating profit and its total revenue. It provides insight into the company’s ability to generate profit from its operations.
- Earnings Before Interest and Tax (EBIT) which measures a company’s profitability before the deduction of interest payments and taxes. This approach is useful for comparing the profitability of companies in different tax jurisdictions.
- Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) which is a measure of a company’s profitability that excludes the cost of financing and taxes. This approach is useful for comparing the profitability of companies in different tax jurisdictions.
- Cash Flow from Operations (CFO) which measures the amount of cash generated by a company’s operations. This approach is useful for assessing the company’s ability to generate cash from its operations.
Summary Underlying Profit is one approach used to evaluate a company's performance, but there are several other approaches such as Operating Profit Margin, Earnings Before Interest and Tax (EBIT), Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), and Cash Flow from Operations (CFO). Each approach provides a different view of the company's profitability and ability to generate cash from its operations.
- CFA Institute 2016, p.220
- S.Briscoe, J. Fuller 2007, p.108
- S. Henderson et al. 2015, p.588
- A. K. Mahanty 2014, p.242
- B. Snow 2011, p.76
|Underlying Profit — recommended articles|
|EBITDAR — Berry Ratio — Cost-income ratio — Adjusted ebitda — Du Pont analysis — Gross margin in retail industry — Combined Ratio — Fixed-Charge Coverage Ratio — Expanded accounting equation|
- Birt J., (ed.) (2019), Accounting: Business Reporting for Decision Making, John Wilej & Sons Australia, Ltd, Australia.
- Briscoe S., Fuller J., (2007), Harriman's Financial Dictionary: Over 2,600 Essential Financial Terms, Harriman House Ltd., Hampshire.
- CFA Institute, (2016), CFA Program Curriculum 2017 Level II, John Wiley & Sons, New York.
- Henderson S., (ed.) (2015), Issues in Financial Accounting, Pearson Australia, Australia.
- Mahanty A. K., (2014) Intermediate Microeconomics with Applications, Academic Pres, Inc., New York.
- Rice A., (2015), Accounts Demystified: The Astonishingly Simple Guide To Accounting, Pearson Education Limited, Edinburgh.
- Snow B., (2011), Mergers and Acquisitions For Dummies, Wiley Publishing, Inc., Hoboken.
Author: Katarzyna Siedlarczyk