Profit analysis involves dissecting the reported profit figure of a business to determine the actual extent of its profitability. This is analysis is needed, because managements routinely report overly optimistic profit information to the outside world.
There are numerous ways in which the profit figure can be modified to present a better outcome than is really the case. In the following analysis steps, we describe a method for improving the odds of discerning the true operational outcome of a business:
- Calculate core earnings. Rather than bothering with the net profit margin at all, use the core earnings formula to strip away a number of areas that are commonly used to modify earnings. Accordingly, strip away the following items from the initial profit figure:
- Asset impairment charges
- Costs related to merger activities
- Costs related to the issuance of bonds and other forms of financing
- Gains or losses on hedging activities that have not yet been realized
- Gains or losses on the sale of assets
- Gains or losses related to the outcome of litigation
- Profits or losses from pension income
- Recognized cost of stock options issued to employees
- Recognized cost of warrants issued to third parties
- Accrued cost of restructuring operations that have not yet occurred
- Deflate core earnings. Use the deflated profit growth calculation to adjust the core earnings figure for inflation, which will reduce the reported profit figure. To do so, follow these steps:
- Divide the price index for the prior reporting period by the price index for the current reporting period; then
- Multiply the result by the net profit figure reported for the current reporting period; then
- Subtract the net profits for the prior reporting period from the result; and finally
- Divide the result by the net profit figure for the prior reporting period.
- Create a trend line. Run the deflated core earnings figure back in time for several years. This gives the best indication of whether management is actually able to generate improvements in profitability over time. It is entirely possible that an initially favorable profit trend is actually a declining trend, once the preceding adjustments have been made.