What is Underlying Earnings?
Underlying profit (sometimes known as underlying earnings) is used by companies to show what they believe is a more accurate representation of the performance of the business. It is a figure reached by eliminating exceptional and non-recurring costs. This is different from the reported accounting profit that is a statutory requirement, allowing more interpretation in its calculation by individual companies. Management will report a calculated underlying profit figure in their MD&A section in the financial statements.
Key Learning Points
- Underlying profit focuses on the regular accounting cycle, and eliminates non-recurring costs and exceptional income
- Every company has its own interpretation of underlying earnings, so it should be treated with caution
- Underlying profit is calculated in order to show what the company believes is a more accurate display of its financial performance
- Underlying provide provides a better understanding of the recurring earnings from the company’s operations and provides better forecasts in financial modeling
Understanding Underlying Profit
Underlying profit is a supplemental figure, derived from the accounting profit that a company is required to disclose by its Generally Accepted Accounting Principles (GAAP). A company calculates these earnings to show investors and users of its financial statements a more suitable indicator of the company’s performance from its core operations.
The aim is to eliminate exceptional and non-recurring costs. These costs are not considered to be relevant to the day-to-day running of the business, and therefore do not reflect the underlying operation of the company.
Usually, only consistent operating expenses and costs of sales will be subtracted from revenue in order to assess underlying profit. These include, but are not limited to:
- Ongoing property expenses, such as rent and business rates
- Payroll costs
- Other employee costs, such as training and professional subscriptions
- Software costs, including one-off costs and subscriptions
- Utility costs
It is up to the analyst to decide which items should be considered as part of the recurring operations of the business. If there is reasonable evidence for the decision undertaken, then it should be included in the calculation.
Removing a Non-Recurring Event to Calculate Underlying Profit
A company reporting under International Financial Reporting Standards (IFRS) has had to make changes to its accounting policies regarding financial instruments, upon adoption of IFRS 9. This has led to them incurring an impairment charge on their bad debts. While this impairment charge must be recorded for accounting purposes, the company does not believe it reflects the ongoing performance of the business, therefore they have excluded it from their underlying profit.
A change in accounting policies leading to impairment is not a recurring part of a business’s operations, so even though it has resulted in an expense, the company has “added it back” for the purposes of underlying profit.
Advantages and Disadvantages
In addition to giving investors a better idea of how a company operates over multiple financial periods, underlying profit is also used by businesses for planning purposes. When determining what revenue, COGS and operating costs is likely to recur in the future, a business is likely to want to remove non-recurring or irregular income or expenditure so that predictions are not artificially inflated. Underlying profit provides a good basis to start this financial planning.
Every company has its own interpretation of underlying profit; it is not guided by GAAP or IFRS. This freedom can make it difficult to compare performance between companies, and should therefore be treated with caution.
It is important that investors and other users of the financial information understand how the calculation has been made, and the company should disclose this in their reporting.
Underlying Earnings and Valuation
Underlying profit is the process of “cleaning up” the data to remove non-recurring items in order to see the underlying trends more clearly. A thorough understanding of the underlying trends of a business i.e. its growth rates, margins and returns is critical for valuation. It enables an objective evaluation of the peer group for comparability and also provides context for the multiples. Any distortions in the underlying trends will undermine the ability of the valuer to make appropriate judgements on the output. Any distortions caused by non-recurring items might have a significant impact on the multiple used for valuation.