Profit analysis
/What is Profit Analysis?
Profit analysis involves dissecting the reported profit figure of a business to determine the actual extent of its profitability. This analysis is needed by outside analysts, because managers routinely report overly optimistic profit information to the outside world. There are numerous ways in which the profit figure can be modified to present a better outcome than is really the case. It is also useful internally, to determine the true sources of an organization’s profits and losses.
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The Interpretation of Financial Statements
The Profit Analysis Process
In the following analysis steps, we describe a method that analysts can use to improve their odds of discerning the true operational outcome of a business:
Step 1. Calculate Core Earnings
Rather than bothering with the net profit margin at all, use the core earnings formula to strip away a number of areas that are commonly used to modify earnings. Accordingly, strip away the following items from the initial profit figure:
Asset impairment charges
Costs related to merger activities
Costs related to the issuance of bonds and other forms of financing
Gains or losses on hedging activities that have not yet been realized
Gains or losses on the sale of assets
Gains or losses related to the outcome of litigation
Profits or losses from pension income
Recognized cost of stock options issued to employees
Recognized cost of warrants issued to third parties
Accrued cost of restructuring operations that have not yet occurred
Step 2. Deflate Core Earnings
Use the deflated profit growth calculation to adjust the core earnings figure for inflation, which will reduce the reported profit figure. To do so, follow these steps:
Divide the price index for the prior reporting period by the price index for the current reporting period; then
Multiply the result by the net profit figure reported for the current reporting period; then
Subtract the net profits for the prior reporting period from the result; and finally
Divide the result by the net profit figure for the prior reporting period.
Step 3. Create a Trend Line
Run the deflated core earnings figure back in time for several years. This gives the best indication of whether management is actually able to generate improvements in profitability over time. It is entirely possible that an initially favorable profit trend is actually a declining trend, once the preceding adjustments have been made.
It can be useful for the analyst to discuss the outcome of this profit analysis with management. Doing so may yield some valid issues that should be incorporated into the analysis. It may also reveal that company managers have, in fact, been using accounting shenanigans to adjust reported profits.
Limitations of Profit Analysis
Profit analysis has several limitations that can impact the accuracy and usefulness of its conclusions. Here are its key limitations:
Focuses on historical information. Profit analysis is often based on past financial data, which may not reflect future performance or consider external changes, such as market conditions or emerging competition. Decisions based solely on historical profits may lead to missed opportunities or overestimation of future profitability.
Excludes non-monetary factors. Profit analysis focuses on financial metrics and often ignores qualitative factors like customer satisfaction, employee morale, or brand reputation. This overemphasis on profitability might lead to short-term gains but harm long-term growth or sustainability.
Inputs can be manipulated. Profit figures can be manipulated through accounting methods like depreciation policies, inventory valuation techniques, or revenue recognition. As a result, profit analysis might not provide a true picture of a company’s financial health due to subjective or creative accounting.
Ignores cash flows. Profit does not necessarily equal cash flow. A company may show profits on paper but struggle with cash flow problems due to delayed receivables or high inventory levels. Misjudging financial health based on profit alone can lead to liquidity issues.
Ignores product cycles. Profit analysis does not account for where products are located in their life cycles, so it cannot predict when their sales will decline, leading to a drop in profits.
Ignores constraints. Profit analysis does not examine the constraints within a business to determine what is holding it back from generating more profits.
Ignores externalities. External elements like economic conditions, legal changes, or industry trends are often not incorporated into profit analysis. Ignoring the broader business environment may result in unrealistic profit expectations.
While profit analysis is a critical tool for decision-making, its limitations necessitate the use of complementary analyses, such as cash flow analysis, market trend assessments, and qualitative evaluations, to achieve a holistic understanding of business performance.