The Hindu Business Line : Many avatars to profits

When analysts or investors talk of a company’s profit growth, they usually refer to its net profits — the profits after interest, depreciation and taxes. But is this the most important measure of how fast a company is growing? Not always. While evaluating a company’s growth, it is important for investors to also pay attention to the profits from the core operations, without considering one-off items. Here’s a brief overview of the distinction between operating profits, profits before exceptional items and the reported net profits for a company.

Operating Profits

Operating profits usually referred to as profits before interest, depreciation or taxes (alternatively EBIDTA) measures the income generated by a company from its main business.

Operating profits are calculated by deducting operating expenses from total revenues. Costs that are incurred in the normal course of business such as cost of raw materials and bought-out goods, salaries and wages paid to employees and other administrative expenses are classified as operating expenses.

Cash profits are important to gauge how much cash a company is generating from its operations. It is computed by adding back depreciation and other non-cash charges to the operating profits Operating profits carry great importance as they indicate the health and profitability of the core business. If a company incurs loss at this stage, it means that its sales revenues are barely adequate to meet its day-to-day working expenses. Take the case of NDTV. Despite a 34 per cent increase in its income from operations for the year-ended March 2009, the company was forced to register an operating loss amounting to Rs 484.40 crore due to a steep increase in personnel expenses and production costs.

Operating profits when divided by sales give a company’s operating profit margins (OPM). The OPM is a crucial number that shows how profitable a particular line of business is.

Businesses that offer high OPMs often enjoy higher valuations on the stock market, as they offers greater cushion to cover fixed and interest costs.

Sectors such as FMCG and IT in the Indian context have higher levels of operating profit margins. Companies within a sector that enjoy a higher OPM may enjoy better valuation than their peers.

Exceptional items

When investors look at a company’s profit growth, their focus is often on the sustainability of the profits arising from the core business. Profits or losses made on sale of assets and investments, write-offs due to impairment or investment losses may not be a recurring feature of a business and thus, will have to be excluded by investors looking for the sustainable picture.

A significant adjustment that finds a mention here is the treatment of foreign exchange gains and losses. Most companies treat this item (arising out of hedge contracts or due to revaluation of foreign currency borrowing), as either ‘other expense (or income)’ or ‘exceptional item’.

While evaluating this item, investors need to find out if the forex component is recurring or one-off in nature. Taxes (including provisions) deducted from profits give the net profit after tax. This is the net earnings left for shareholders after accounting for all expenses. Dividends are paid out of this profit.

The above factors suggest that the profits reported by a company through its published advertisements are often not the final word on how the company has fared. The question really is, how much of that growth is sustainable.

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