What is Underlying Profit?

What is Underlying Profit?

Underlying profit is the measure used internally to evaluate performance, to establish strategic goals and to allocate resources. In most years it is based on EBITDA (earnings before interest, tax, depreciation and amortisation).

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 annualtypically 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.

See also :  What is Historical Cost?

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, 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.