Underlying Profit Explained A Clear Guide for Investors

Core Description

• Underlying profit is a management-defined, non-GAAP financial metric designed to capture a company’s recurring profitability by excluding non-recurring or non-core items.
• This measure helps investors and stakeholders assess the durability and quality of a firm’s core operations over time, smoothing out “noise” from exceptional events.
• While valuable for analyzing earnings trends, underlying profit requires scrutiny regarding adjustments made, consistency, and full reconciliation to statutory (GAAP/IFRS) results.

Definition and Background

Underlying profit is a financial metric that management uses to highlight what they consider the sustainable earnings power of their business. Unlike statutory profit, which follows accounting standards and includes every recognized expense, gain, or loss within a period, underlying profit is a non-GAAP (or non-IFRS) figure that removes items deemed unusual, non-recurring, or not core to regular business activity. Common exclusions include restructuring costs, asset impairments, litigation settlements, acquisition-related charges, and extraordinary fair value swings.

This concept gained traction as companies and investors recognized the limitations of statutory profit in reflecting the ongoing financial health of a business. Since the 1990s, when the use of alternative performance measures increased, regulatory bodies such as the SEC and ESMA have required that non-GAAP figures be reconciled transparently to audited, statutory numbers.

Underlying profit metrics are now common in global investor communications, especially in earnings releases and management presentations. Well-known companies such as Tesco, Rio Tinto, and Unilever regularly disclose underlying profit to provide additional insight into their operating performance. However, because underlying profit is not standardized, its definition and calculation may differ across companies and sectors, requiring careful examination by analysts and investors.

Calculation Methods and Applications

Calculation Approach

Underlying profit is typically calculated as follows:

1. Starting Point: Begin with statutory net income or operating profit, as reported under GAAP or IFRS.
2. Exclusions: Adjust by removing specified non-recurring or “one-off” items. These may include (but are not limited to):
   • Restructuring and severance costs
   • Impairments and write-downs
   • Acquisition-related costs and amortization
   • Fair value movements on financial instruments
   • Litigation settlements
   • Gains or losses from asset sales
   • One-off tax effects and regulatory changes
   • Effects of discontinued operations, disasters, or hyperinflation
3. Normalization: Adjust for tax and interest impacts as necessary for comparability. Many companies also present underlying profit on a “constant currency” basis to remove exchange rate movements.
4. Reconciliation: Transparently document each exclusion, including the amount and rationale, in detailed tables or footnotes linked to statutory results.

Example Calculation (Fictional Case)

Suppose a large retailer reports USD 200,000,000 in statutory net income for the year. Management excludes the following as one-time impacts:

• USD 30,000,000 for restructuring costs from store closures
• USD 10,000,000 from a legal settlement
• USD 15,000,000 gain from a major property sale

Underlying profit = USD 200,000,000 + USD 30,000,000 + USD 10,000,000 - USD 15,000,000 = USD 225,000,000

Applications

• Trend Analysis: By stripping out volatile or exceptional items, underlying profit allows managers and investors to discern operational trends and the “core” profitability of a business.
• Peer Comparison: Adjusted numbers can facilitate more meaningful comparisons across companies in the same industry, provided definitions are consistent.
• Budgeting and Incentives: Management uses underlying profit to set internal targets, guide resource allocation, and align performance-based pay with controllable factors.

Comparison, Advantages, and Common Misconceptions

Comparative Analysis

Underlying Profit vs. Statutory Profit

• Statutory profit complies fully with GAAP/IFRS. It includes recurring operations, one-time items, and all recognized income and expenses.
• Underlying profit is adjusted to remove items management views as non-recurring or non-core. Transparent reconciliation is necessary to avoid selective exclusions.

Underlying Profit vs. Other Metrics

Advantages

• Clarity: Offers a clearer signal of recurring profitability by filtering out noise from exceptional or irregular events.
• Comparability: Facilitates year-on-year and peer analysis when well-defined.
• Decision-making: Informs management decisions and investor modeling by clarifying core operational trends.
• Performance incentives: Supports frameworks for bonus and resource allocation based on controllable performance, not external shocks.

Limitations and Common Misconceptions

• Subjectivity: Choices about what constitutes a one-off or non-core item are discretionary and may be open to interpretation.
• Comparability Issues: Definitions and exclusions vary, making cross-company analysis challenging without detailed disclosures.
• Non-audited: Underlying profit is not part of audited financial statements; relying on it alone can be misleading.
• Misconceptions: Some investors mistakenly equate underlying profit to EBITDA or assume higher underlying profit is always preferable, without considering the nature of exclusions or cash flow implications.

Practical Guide

Setting Policy and Governance

1. Clear Scope: Define the purpose for which underlying profit will be used (valuation, budgeting, covenants).
2. Consistency: Establish and publish rules for which items are excluded, including materiality thresholds, and apply these rules consistently over time.
3. Documentation: Provide detailed reconciliation to statutory profit, explaining all exclusions and clarifying tax effects.
4. Board and Audit Committee Oversight: Route all significant adjustments through governance channels to prevent biased reporting.

Implementation Checklist

• Set quantitative thresholds for exclusions (e.g., only items above USD 5,000,000).
• Always treat both exceptional gains and losses symmetrically.
• Outline and archive the methodology and adjustment policy for transparency and repeatability.
• Confirm with external auditors whether disclosures comply with local requirements.

Testing Quality

• Compare underlying profit trends with free cash flow and return metrics to validate earnings quality.
• Benchmark peer metrics, but check the underlying definitions.
• Use scenario and sensitivity analyses to evaluate the impact of recurring versus non-recurring adjustments.

Virtual Case Example

A global consumer products company in a competitive market reports underlying profit as follows (all data fictional):

• Operating Profit (GAAP): EUR 100,000,000
• Exclusions: EUR 20,000,000 impairment of legacy software, EUR 5,000,000 restructuring (factory closure), -EUR 3,000,000 foreign exchange gain
• Underlying Profit: EUR 100,000,000 + EUR 20,000,000 + EUR 5,000,000 - EUR 3,000,000 = EUR 122,000,000

The company discloses these adjustments in the footnotes, and the audit committee reviews their appropriateness. Investors use the EUR 122,000,000 as a basis for peer comparison but note that a competitor includes software impairments in recurring expenses. This highlights the need to understand each company’s adjustment policy.

Practical Points for Investors

• Always review the reconciliation tables between statutory and underlying profit.
• Question items labeled as “non-recurring” if they appear frequently. Recurring restructuring, for instance, may indicate cost structure concerns.
• Focus on transparency, governance, and multi-year consistency when evaluating the reliability of reported underlying profit.

Resources for Learning and Improvement

• Regulatory Guidance: SEC Regulation G, ESMA APM Guidelines, IOSCO Statement on Non-GAAP Measures
• Books: “Financial Statement Analysis” by Stephen H. Penman; “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company
• Professional Organizations: CFA Institute publications on non-GAAP measures
• Company Resources: Review disclosures and reconciliations in annual and interim reports of companies such as Unilever, BP, and Rio Tinto
• Investor Education: Explore online courses and videos on financial statement analysis and alternative performance measures
• Research Platforms: Financial data aggregators and investor tools may provide cross-company underlying profit analysis and comparison

FAQs

What is underlying profit, and how is it different from statutory profit?

Underlying profit is a management-defined, non-GAAP metric adjusted to exclude non-recurring or non-core items. Statutory profit includes all items required by accounting standards. Underlying profit is intended to reflect repeatable earnings, while statutory profit includes all financial impacts.

What items are commonly excluded from underlying profit?

Common exclusions include restructuring costs, impairments, acquisition-related expenses, litigation settlements, fair value gains/losses, gains on asset sales, and extraordinary tax impacts. Each exclusion should be disclosed and justified.

Are depreciation and amortization included in underlying profit?

Regular depreciation and amortization are usually included, unless specifically related to acquisitions or exceptional write-downs, which may be excluded based on company policy. Always check the notes for details.

Why do companies report underlying profit?

Companies use underlying profit to communicate their core business performance, reduce noise from irregular events, and align external messaging with internal targets. It assists investors and analysts in comparing ongoing profitability across periods or companies.

How can investors assess the reliability of a company’s underlying profit?

Review the reconciliation to statutory profit, check the consistency of adjustments across years, assess whether excluded items are genuinely non-recurring, and compare cash flow generation. Reporting standards should be analyzed carefully.

Is underlying profit audited?

No, underlying profit is not audited as part of statutory financial statements. Audit committees and regulators may review definitions and reconciliations for consistency and to prevent misleading disclosures.

Where can I find underlying profit metrics for a company?

Look in earnings announcements, management discussions and analysis (MD&A) sections, investor presentations, and footnotes of financial statements. Regulatory filings may require reconciliation to statutory numbers.

Can underlying profit vary widely between companies in the same industry?

Yes. Underlying profit is management-defined, and differences in exclusion policies and industry conventions can result in significant variation. Always review the definitions and reconciliation notes to understand any differences.

Conclusion

Understanding underlying profit is important for any investor or financial analyst seeking to interpret company earnings by removing the effect of one-off or exceptional items. While this non-GAAP metric can provide a clearer view of recurring operating performance, its usefulness relies on transparent disclosure, consistency of definitions, and rigorous reconciliation with statutory results.

Underlying profit should not replace statutory results for critical corporate decisions or valuations. When used carefully, it can add depth to trend analysis, peer comparison, and performance evaluation. Regardless of experience, always approach underlying profit measures critically, check against other metrics like cash flow, and stay alert to any changes in how these measures are defined or reported.

By consulting regulatory guidance, reputable texts, and company disclosures, and by maintaining a questioning and analytical mindset, you can make more informed evaluations of company performance through underlying profit analysis.