Your company, division, or product line is making lots of money. So says your income statement. That’s good. But those are accounting profits — they
exclude
the cost of equity and more.
Economic
profit, on the other hand, is for all practical purposes, adjusted accounting profit less the cost of equity.
It’s not at all the same thing.
I wrote at length about the cost of capital and how to measure it,
here
. Simply stated, it is the weighted average of the cost of equity, plus the cost of debt, with each component costed at current market rates.
So, what is the economic cost of equity?
It is the return required in the marketplace for equity in a business that is similar to yours.
How do you find out what that is? Typically, by asking an investment banker or someone who does business valuations. In most cases, access to private databases is needed.
The point is,
financial accounting does
not
charge for the cost of equity.
So you have to take that out of your profits to get a true picture of whether or not you are “making money.”
Understanding Adjusted Accounting Profit
Here are the three most common adjustments…
#1. Having the wrong depreciation period for fixed assets.
I worked with a high-end party rental company that amortized tables, chairs, and assorted furniture over five years. Why five years? Because that depreciation rate was called for to do a tax return; only one depreciation schedule needed to be maintained. The adjustment can go the other way as a result of goodies in the tax code such as the investment tax credit, bonus depreciation, and more.
This problem can surface in amortization rates for tooling and so forth.
Also, the rate of depreciation may vary as the asset ages. A simple example is owning a car. The value drops a lot as soon as it is driven off the lot, quite a bit the following year, but by less with each successive year. If accounting uses straight line depreciation, the cost is understated in the early years and overstated in the later years.
#2. When market rates or costs differ from what is used for accounting purposes.
A common example is when the rent charged to the operating entity by the real estate entity is below market, something that often occurs when the real estate has risen substantially in value.
Another example is when there is a dramatic change in price of the cost of goods
(in either direction), but inventory is not adjusted accordingly.
#3. When there are expenses a new buyer would likely not consider or incur.
This is often found in private companies and includes things like above market owner/family salaries, excessive T&E, and so forth. Management fees to institutional owners such as private equity firms is another common example.
Why does this matter?
If the business is not earning at least its economic cost of capital, it generates less cash than if it did.
Less cash means less funds to invest in the business, be it CAPEX (machines equipment, etc.) or operating expense (product development, R&D, marketing, etc.). Or, too much debt is incurred, liquidity tightens, and there is also less to invest in the business.
Each of these can lead to a lack of marketplace competitiveness, slower (or zero) growth and overall stagnation, or, worst of all, decline. At that point, the business can’t be properly funded with internal cash flow and/or affordably priced new capital.
Now what?
Measure the business accurately.
You need to know where the money is going and not going, and you need to make sure you are accurately measuring its profitability.
Common problems include depreciation that is too low, poor product costing, and not tracking profitability at a meaningfully executable level (i.e., profitability and investment by product, customer, channel, and so forth). Above market rate compensation to related entities can provide similar distortions, as can allocations of corporate overhead.
Sometimes it makes sense to track/calculate economic profit outside of the financial statements, particularly if your business is very large.
Don’t let lifestyle drive your decisions.
This is true for both direct business owners and private equity funds that “need” a certain level of management fees to help cover their own expenses, and that use this to determine how much they take out of the business. When your business’s profitability declines, there is less to take out, so make changes as needed.
Stop doing what you’ve been doing.
This may seem obvious, but at some point, stopping is not easy. Commitments both internal and external to the business may have been made, whether family-related, personal loans, private equity funds, salaries, rent, and so forth. These are hard to address and beyond the scope of this newsletter.
Set realistic expectations.
Economic theory suggests that economic profits should be competed away to zero. So the key is to make sure economic profits are not negative. If economic profits are large, then unless you have some sort of monopoly such as patents, trade secrets, copyrights, or other government forms of protection, then something is likely wrong with your measurements.
Does This Apply in a Big Company?
In a word, yes. Although figuring out your economic return is more complicated and harder to do.
As a starter, how many of the line items on your P&L are poorly understood “allocations?”
(For help, read
here
and
here
.)
Hint, besides taking into account the economic cost of equity, large businesses need to take into account the difference between the economic cost and the accounting cost of debt. Lucky you.
Conclusion
“Making Money” is an imprecise term, one with several possible definitions depending on the measures used and the circumstances involved.
To grow your business consistently and successfully, make sure you understand your cost of equity and the
real
economic profit of the business, and that you translate it accurately into practical business measures and decisions.
