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“What, me worry?
”
This expression, made famous more than half a century ago by the always poorly informed
Alfred E. Neuman of Mad Magazine fame, still has application today.
That’s because many business owners assume their business is profitable (when it may not be) because they rely solely on financial statements.
GAAP profitability from financial statements is critical, absolutely. But this is accounting profit, something that is reduced by the cost of debt, but not the cost of equity.
Economic
profit, by contrast, includes the market cost of debt
and
equity (the cost of capital).
Economic profit also adjusts GAAP accounting profit in other ways to reflect economic reality.
Owners can get a better risk-adjusted return by selling the company and investing the proceeds elsewhere if the business is not earning an economic return. Worse, a business that does not continually earn an economic profit will lack the funds to invest in the business and stay competitive.
Perfection is Not Required
All that said, calculating economic profit perfectly can be complicated; there is an industry of consultants that specialize in it.
Fortunately, calculating the
basics
— being directionally correct — is still very useful and not so difficult.
Overall, this requires adjusting accounting profit to reflect economic reality, calculating the cost of capital, and subtracting that cost from the adjusted accounting profit. More specifically…
#1. Start with income before taxes and interest from the financial statements.
#2. Adjust depreciation to reflect economic reality.
First, the asset should be depreciated over its useful life.
One client of mine that did this incorrectly was 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; this meant only one depreciation schedule needed to be maintained. Similar problems can surface in amortization rates for tooling and so forth.
Second, the rate of depreciation may vary as the asset ages. A simple example is owning a car. The value drops considerably as soon as it is driven off the lot, then quite a bit the next year, but by less each successive year. So, if accounting uses straight line depreciation, the cost is understated in the early years and overstated in the later years.
#3. Use market rates for owner compensation, rents on owner-owned real estate, loans, etc.
Be honest and don’t include things that someone operating the business as a public company would not have. For example, a former client in the construction business put one of the owners’ sons on expensive union benefits because his wife was pregnant and the union plan covered pregnancies in full.
#4. Adjust for unusual non-reoccurring items,
such as a gain on the sale of part of a business, forgiven PPP loans, and Employee Retention Credits.
#5. Subtract the cost of taxes.
Here, I differ from theory a bit to keep the calculation simple. If your business is a C-Corp (i.e., the company pays the taxes directly and not its owners), use the tax expense from the tax return for that year. If it is not, use taxable income at the owners’ marginal tax rate.
#6. Adjust for the cost of capital.
I wrote at length
here
about the cost of capital and how to measure it. It is the weig
hted average of the cost of equity plus the cost of debt, with each component costed at
current market rates.
Again, accounting profit does not include the cost of equity;
the cost of debt is the cost of
contracted
debt, not the cost of debt in today’s market.
As a practical matter, the market cost of debt matters for fixed rate debt and not so much for floating rate debt such as on a line of credit.
What is left is economic profit.
Economic theory says businesses compete away economic profit and so it should be zero. So if your calculations reveal a large economic profit or loss for your business, double-check the calculations.
Using Economic Profit
Suggestions…
-
If your business is
underperforming despite financial statements that show a profit
, improved financial performance is needed.
-
Translate
the economic measures to accounting measures.
For example, what approximate return on equity (ROE) is needed to make an economic profit? For larger companies, this may mean business units need a balance sheet for which they are responsible.
-
When evaluating business opportunities and investments,
make sure you expect to make an economic return,
taking into account your cost of capital and the adjustments needed from your financial statements. This can be converted into a hurdle rate of return that all new projects must clear. Keep things simple.
-
Make
economic profit the starting point before thinking about distributions of any form from the business.
If business owners take more from the business than the economic value of the company, they are diminishing the company’s value. “Take” examples include above market compensation for owners, personal expenses run through the business, above market rents for owner-owned real estate, and management fees paid to private equity owners.
A Few Pointers…
-
Unless you are a large company with the requisite in-house talent, get outside help to understand your true cost of capital. There is an army of these consultants for larger companies. If you have had a valuation done for tax or other purposes, these people likely came up with your true cost of capital — importantly, the cost of equity — and can figure it out if they didn’t. You may also need outside help converting GAAP income to economic income.
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Pass-through entities with multiple owners pose a special challenge because the owners may have different tax rates. Get outside help in these situations.
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If your company enjoys substantial tax credits, my simple approach to taxes might be misleading, so get help.
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Have a good profitability measurement system that measures profit for products, customers, and markets. Know its limitations, especially when it comes to costing and allocations. If possible, get market costs for products, markets, or locations. For example, a light industrial staffing client of mine uses job-specific workers' compensation rates in its internal customer profitability measurement system.
-
Use the right time frame.
I have discussed this
in the past. The right time frame depends on what decision or assessment you are making.
Final Thoughts
GAAP (accounting) profit is foundational. Proper accounting and controls with good financial statements remain key.
However,
understanding economic profit is critical to understanding the financial performance of any business.
It is also critical when making resource allocation decisions such as capital expenditures, acquisitions, and other projects.
Get help if needed to understand your
true
cost of capital.
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