Pay Attention to ProfitabilityOn October 3, Forbes published an excellent article by Partha Mohanram, an associate professor at Columbia Business School, that is a timely reminder of why you should look at least as closely at a company's balance sheet as at its income statement when assessing the company's financial health.
Mohanram's central point is the necessity of recognizing the distinction between profit the difference between revenue and expenses and profitability the amount of profit relative to the amount of assets the company is using to earn its profit.
Once one begins reflecting on the distinction between profits and profitability, several other points come to the fore:
- Profitability can be falling even if profits are rising. This happens whenever the growth rate of assets exceeds the growth rate of profits.
- The quality of assets matters. In particular, the risk of loss of value for each category of asset is of essential importance.
- You have to look at the footnotes to the balance sheet to check for "offsheet" items that need to be added back in in order to get a true picture of the company's financial condition.
Managers should care as much about what any new transaction brings to their balance sheet as what it brings to their income statements. Analysts should stop focusing exclusively on EPS [earnings per share] targets and also forecast profitability targets. ...In other words, ensuring that managers and, ideally, that employees in general have solid business acumen is fundamental for enabling value-creating business decisions.
The business press should stop facilitating the negative cycle caused by an emphasis on profits and growth without regard to the assets used to derive them. Boards of directors should reward managers for growth in profitability, not profit, by incorporating measures such as residual income (earnings less a charge for capital employed) in deciding executive compensation. Regulators should clamp down on off-balance sheet items, a lesson that apparently wasn't learned from the Enron debacle. Finally, business academics must train the next generation of managers, financial analysts and investment bankers to understand the critical difference between profit and profitability.