Showing posts with label economic profit. Show all posts
Showing posts with label economic profit. Show all posts

Wednesday 1 September 2010

Profit (accounting)

In accounting, profit is the difference between price and the costs of bringing to market whatever it is that is accounted as an enterprise (whether by harvest, extraction, manufacture, or purchase) in terms of the component costs of delivered goods and/or services and any operating or other expenses.

Definition

There are several important profit measures in common use which will be explained in the following. Note that the words earnings, profit and income are used as substitutes in some of these terms (also depending on US vs. UK usage), thus inflating the number of profit measures.

Gross profit equals sales revenue less Cost of Goods Sold (COGS), thus removing only the part of expenses that can be traced directly to the production of the goods. Gross profit still includes general (overhead) expenses like R&D, S&M, G&A, also interest expense, taxes and extraordinary items.

Operating profit equals gross profit less all operating expenses. This is the surplus generated by operations. It is also known as Earnings Before Interest and Taxes EBIT, Operating Profit Before Interest and Taxes OPBIT or simply Profit Before Interest and Taxes PBIT.

(Net) Profit Before Tax PBT equals operating profit less interest expense (but before taxes). It is also known as Earnings Before Tax EBT, Net operating income before taxes or simply Pretax Income.

Net profit equals Profit After Tax (unless some distinction about the treatment of extraordinary expenses is made). In the US the term Net Income is commonly used. Income before extraordinary expenses represents the same but before adjusting for extroardinary items.

Net income less dividends becomes retained earnings.

There are several additional important profit measures, notably EBITDA and NOPAT.

To accountants, economic profit, or EP, is a single-period metric to determine the value created by a company in one period - usually a year. It is the net profit after tax less the equity charge, a risk-weighted cost of capital. This is almost identical to the economist's definition of economic profit.

There are commentators who see benefit in making adjustments to economic profit such as eliminating the effect of amortized goodwill or capitalizing expenditure on brand advertising to show its value over multiple accounting periods. The underlying concept was first introduced by Schmalenbach, but the commercial application of the concept of adjusted economic profit was by Stern Stewart & Co. which has trade-marked their adjusted economic profit as EVA or Economic Value Added.

Some economists define further types of profit:
Optimum Profit - This is the "right amount" of profit a business can achieve. In business, this figure takes account of marketing strategy, market position, and other methods of increasing returns above the competitive rate.

Accounting profits should include economic profits, which are also called economic rents. For instance, a monopoly can have very high economic profits, and those profits might include a rent on some natural resource that firm owns, where that resource cannot be easily duplicated by other firms.

http://en.wikipedia.org/wiki/Operating_profit

Saturday 24 April 2010

Shareholder value and Economic Profit

Shareholders invest in a company to make a profit.  This can come from an increase in the share price and/or the dividends the company pays.

The challenge is to find a measure of business performance that correlates with share price movements.  Then, if we plan our business to raise this measure, we should raise the share price, and hence create value for our shareholders.



EBITDA

Earnings before interest, tax, depreciation and amortisation (EBITDA)

Profit is not a good measure of the value a business is generating for its shareholders.  Ultimately, a shareholder is interested in the amount of cash generated, rather than profit (which is after all only an accounting calculation). It is cash which enables the business to expand and develop, and pay dividends.  And it is the expectation of future cash flows that drives the share price up, and creates values for shareholders.

In calculating profit, depreciation is included as a cost.

Depreciation and amortisation are not cash transactions but an accounting exercise to balance the reducing value of assets over time.  We can measure earnings before interest, tax, depreciation and amortisation - EBITDA!  This is the amount of operating profit that will eventually be turned into cash.  But EBITDA alone doesn't tell us if we are creating value.


Economic profit or Economic Value Added (EVA)

Economic profit (EP) takes account of the fact that investors have choices.  They can invest in your company, or your competitor; in art; in another industry; or put their money in the bank.  Every investment has a certain amount of risk, and a level of reward.

If your company generates more cash for each pound invested than other investments with a similar level of risk, it is making an 'economic profit'.  

  • Studies of real companies show clearly that an increase in EP correlates strongly with an increase in share price, and the creation of shareholder value.  
  • A fall in EP goes with a reduction in share price, and destruction of shareholder value.


Economic profit is calculated by taking the cash flow generated by the business (EBITDA) and subtracting a 'charge' for the 'cost of capital'.  The cost of capital is the profit the business must make, simply to meet the expectations of investors who take this level of risk.

If the company was financed only by shareholders' funds, the cost of capital would be the average return of investments after tax with the same level of risk; for example, a group of companies of similar size in the same industry.  This is the 'cost of equity'.

Most companies are financed partly by shareholders' funds, and partly by bank loans.  So, their cost of capital is not simply the cost of equity, but takes into account the interest paid on loans as well.  This is known as the 'weighted average cost of capital', or the WACC rate.

Economic profit is calculated by

  • subtracting a capital charge (the net asset value of a business multiplied by the WACC rate) from EBITDA.  
  • Tax is also deducted because this is paid out of cash flow.  
  • Interest is not deducted, as the capital charge has already taken this into account.


Economic profit = Profit (Earnings) - Tax - Capital charge

Capital charge = Net Asset Value of a business X WACC rate


Example of application of Economic Profit
http://spreadsheets.google.com/pub?key=t7BiKoYpNh8QNDvzcZoN8xA&output=html