Monday, December 8, 2008

What's your Profit?

Recently, I was working on an assignment that involved analyzing financial statements for a company. It does not take a finance-major to calculate profits of the company - it is that simple!
However, calculating "economic profit" can be tricky as it is not same as the "accounting-profit" we are accustomed to seeing in corporate profit and loss statement.
Economic profit is a term used for "Economic Value Added (EVA)" - a registered trademark of Stern Stewart & Co. To many, the EVA metric is shrouded in complexity - and therefore, wanted to spend some time explaining this concept in very simple terms. Moreover, in this post, I will try to give you a perspective on the importance of this metric - as I found it during my financial analysis of the company which reported net profits in their annual report but had a negative EVA; in other words it incurred "economic loss".

So if you are scratching your head over this, you are not alone. It is a new concept so many business leaders do not know about this and those who understand it (i.e. CFOs, CEOs, COOs) do not necessarily care about it as much because financial markets still use "account profit" or coporate earnings as a key performance metric for public companies. However, recently, I have been reading about companies such as Eli Lilly (a pharma-major) reporting "economic profit" in the financial highlights section of Annual Report. Not only that, more and more companies are using EVA for internal reporting and bonuses.

Why is it important for you to know about "economic profit"? Besides, the fact that it should make you feel smarter! You should understand it because it is at heart of the business- measure of operation's "true" profitability. And did I tell you that it has generated a growing interest among financial analysts who are often comparing company's reported "accounting profits" with their true "economic profits".
UNDERSTANDING EVA (ECONOMIC PROFIT): If you have looked at the income statement, you would know net earnings (net income or profit) is measured as follows:
or "Accounting Profit") ..........................(A)

SO WHAT IS WRONG WITH THIS? The cost of debt capital (or interest expense) is deducted when calculating Net Earnings, but no cost is deducted to account for the cost of common equity.
Hence, in an economic sense , net earnings overstates "true" income. EVA overcomes this flaw in conventional accounting.
EVA (or economic profit) is found by taking the net operating profit after taxes (NOPAT) for a particular period (such as a year) and subtracting the annual cost of ALL the capital a firm uses. EVA recognizes all capital costs, including the opportunity cost of the shareholder funds.
EVA = NOPAT - After-tax cost of total capitaL
= Earnings before Interest and Taxes (EBIT) * (1-tax rate)
- (Total Capital) * (After-tax cost of capital)
WHOAAA!! If I lost you in this financial "jargon" of the cost of capital, debt and equity; let us take a moment to review few basic concepts of financing:
Companies often invest in growth projects and operations. These projects require external or internal financing to fund these projects or investments. Internally, companies use their cash and retained earnings. Externally, companies generate this capital either by DEBT or EQUITY financing. If a company apply for a bank-loan or issues corporate bonds, it is terms as debt financing. The company incurs a cost of debt capital (referred as "interest expenses" ) in addition to principal amount due in fixed term.
Alternatively, a company can also issue stocks (equity) in exchange for shareholders' funds. This is called "equity financing". Just like cost of debt capital, equity capital has a cost because funds provided by shareholders could have been invested elsewhere where they would have earned some return. The return they could earn elsewhere in investments of equal risk represents the cost of equity capital. This cost is an opportunity cost rather than an accounting cost, but it is quite real nevertheless.

Unless you are in finance or accounting, I doubt if you'll ever use EVA calculations at work. But as a business leader you should always remember that EVA is a measure of company's "true" economic profit. Such economic profits are the basis of shareholder value creation - purpose and goal of any business.

RECOMMENDED READING: Following are two books, I recommend reading on the subject of EVA and its implementation.

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