What is Underlying Profit?
Underlying profit is an internal profit calculation that a company uses as it more accurately portrays the earnings of the business than a standard accounting metric such as net profit.
A company may then elect to report the underlying profit figure in the notes accompanying their official financial statements as additional information to their shareholders. In the United States, financial statements and notes are prepared using Generally Accepted Accounting Principles (GAAP). In the European Union, the governing authority for reporting and publishing official financial statements is the International Financial Reporting Standards (IFRS).
Canadian companies typically follow the IFRS; however, financial regulatory agencies in Canada provide an exception for Canadian companies that are required to report their financial statements in the U.S.
- Underlying profit is an internal profit calculation that a company uses as it more accurately portrays the actual earnings of the business.
- Underlying profit figures are contrasted with statutory profit figures – the number that standard accounting practices require a company to report on its income statement.
- The calculation of underlying profit aims to eliminate one-off gains or losses that are unlikely to reoccur and are not part of a company’s day to day business operations.
The Underlying Profit Metric – Calculation and Example
So, what exactly is “underlying profit,” and how does it differ from the traditional earnings or the net income figure? Why do some companies think that it’s a more accurate representation of their actual profitability? The answer, of course, lies in what comprises the calculation of underlying profit.
The calculation of underlying profit – as opposed to what is referred to as “statutory profit,” the profit figure that is required to be reported in a company’s annual income statement – typically excludes certain figures that are included in the calculation of the statutory profit number. For example, a calculation of underlying profit often excludes what are known as “one-off” gains or losses for a company.
Assume that a company decides to sell off one of its major assets – a manufacturing plant – because company executives believe the business can operate more efficiently by consolidating all of its manufacturing processes at its main manufacturing facility. The sale of such a major asset might produce an extraordinarily large gain, which is added to net income.
Therefore, the company might well choose to calculate the underlying profit figure that excludes the one-time profit from the sale of its manufacturing facility, because that would be more representative of the company’s ordinary earnings from its core business operations.
The example above illustrates the fact that underlying profit calculations look to exclude unusual income or expenses the company experiences as a result of events that are not likely to recur year-to-year in the company’s regular course of doing business.
As another example, an underlying profit figure may also exclude anything that the company considers an extraordinary, non-recurring expense, such as a substantial payout of severance pay that might occur when a company decides to significantly reduce its workforce.
Financial analysts often exclude anything considered a one-time charge when they create a financial model with the purpose of projecting the future earnings of a business.
Sometimes, an entire industry may gradually shift what it considers to be the calculation that most accurately reflects its true earnings. For example, the pharmaceutical industry as a whole has, over time, come to the decision that research and development impairments should not be included in regular earnings calculation, and, therefore, pharmaceutical companies regularly exclude that cost when calculating underlying profit.
Extra profits or losses that are the result of foreign currency exchange rate changes are another common exclusion from calculating underlying profit. While such profits or losses are real, they (a) are not a result of the company’s ordinary business actions, and (b) will change from year to year, and a company has no control over whether the changes will be favorable or unfavorable for its bottom line.
A Cautionary Note
An underlying profit figure may indeed be helpful to investors and analysts by providing them with a more reliable representation of how a company is doing in terms of generating profits from year to year. However, it’s also possible that an underlying profit that a company refers to muddies up rather than clarifies things.
Some companies have been found to publish an underlying profit figure that appears favorable, but that, in fact, represents an attempt to hide the company’s real expenses and make it appear more profitable than it actually is.
Financial analysts should, therefore, always exercise great care when constructing a financial model so that what’s included and excluded results in the most accurate projection possible of the likely future earnings of a business.
Whether the figure is accurate or inaccurate, investors should pay attention whenever a company presents an underlying profit figure that differs significantly from its reported statutory profit.
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