Saturday, August 19, 2006

P&L Reloaded: Net Profit

As with Hollywood as its sequel, prequel and trilogy and quadrilogy. We revisit the P&L or income statement with a vengeance. This time we vent our anger on Net Profit.

The Net Profit is usually the last line in the P&L statement and is usually the number that is most looked at, much like the youngest and most beautiful daughter in the family. In reality, this no. bears little significance to the operations of the company but as we know Wall Street, they like things most when they do not make sense.

Net Profit has little to do with the company’s business because it measures a lot of "costs" that are progressively less relevant to the company's core operations. To recap, we all know that the most relevant costs of any business operations will be

  1. Cost of Goods Sold (COGS)
  2. Sales, General and Adminstrative Expenses (SG&A)

The no. after these costs are subtracted is the Operating Profit (OP). After OP, interest expenses are deducted, because lenders take the first cut of what is left as they always do. Of course the some companies do not borrow, so they have interest income instead. The number after interest is accounted for is called by various names like Recurring Profit or Ordinary Profit or Earnings Before Tax and extraordinary items etc.

After this, we have extraordinary losses or gains (also known as XO loss or gain, not to be confused with the other XO which is a hard liquor). This is where companies hide all the bad stuff usually and you see extraordinary losses or gains every year, which makes you wonder if they are extraordinary or exactly ordinary.

After that, we have taxes and after taxes we finally come to Net Profit, which is profit that is attributable to the shareholders of the company. (If you think about it, shareholders are ranked behind 1. Customers 2. Workers, 3. Debt holders, 4. Disasters 5. the Taxman, which makes investors the lowest lifeform.) You must understand that at every level, no.s are subjected to manipulation and hence when it comes to Net Profit, this no. actually has no integrity left.

Nevertheless, when Net Profit is divided by the no. of shares outstanding (i.e. no. of shares issued by the company which is still in circulation), we get another big ticket no. called EPS, or earnings per share. EPS is the most talked about no. on Wall Street because it is used to calculate the Price Earnings Ratio, or P/E ratio. And this ratio determines how cheap or expensive is the stock.

Post a Comment