Underlying Profit

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Underlying Profit Meaning

Underlying profit is an accounting treatment that involves an actual calculation of the profits that divert from the reported figures in the financial statements. To derive accurate figures, it aims to cut one-time gains and losses from the previous-calculated or reported profits.

Underlying Profit

The underlying profit is a crucial element when considering investment-related decisions. It helps the investors and stakeholders to overview the accuracy of the financial records. Additionally, they gain more insights into the company's performance. However, the underlying profit calculation might vary depending on the industry and firm type. Hence, this concept helps investors and analysts assess the company's ability to generate profit from its core business activities.

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  • Underlying profits is an accounting method in which firms calculate actual profits by eliminating certain non-recurring items and one-time gains and losses.
  • They help the investors determine the factual image of the company's financials. Also, they predict the company's financial health and performance.
  • The formula for underlying earnings includes reporting profits less non-recurring items and other adjustments. Also, they have no regulation or financial standard to adhere to.
  • These differ from statutory profits since these provide an accurate reflection of the company's sustainable operating performance. At the same time, statutory profits represent the entire financial performance without excluding any exceptional item.

Underlying Profit Explained

Underlying profit in annual reports is a hidden or secretive calculation of profits performed by the company. It gives accurate insights into the actual profits that the firm has earned. However, this method tries to neglect or remove certain expenses that have a single occurrence. Alternatively, they are also known as underlying earnings.

Various items serve as one-time gains or losses to the business. Moreover, the firms exclude items with one-time or no relation to the business. Some items are listed below. Let us look at them:

1. Cash from the sale of land or long-term asset

2. Non-recurring expenses like litigation costs, sudden expenses for property damage, and similar costs.

3.  Reconstruction or environmental damages on land or buildings.

4.   Expenses incurred during relocation.

5 .  Impairment costs of goodwill and other assets  

6 Losses as a result of discontinued operations and others.

Furthermore, various factors influence the underlying profits before tax. It includes factors at both internal and macro levelsā€”for instance, technological changes, competition, taxation and government policies, and others. However, there is a crucial reason to exclude non-recurring items. While these gains or losses occur once, they have no role in the business operations. As a result, including them does not justify the revenues earned as they are not from the primary business.

Instead, it focuses on the profit generated from a company's core business operations. This includes revenue and expenses directly related to the day-to-day activities that form the company's primary source of income. Thus, recurring underlying profit is a valuable measure for assessing the fundamental, ongoing profitability of a business over time. In addition, understanding underlying profit after tax can be valuable for investors as it provides a more stable and consistent measure of a company's performance, factoring in the impact of taxes.

Formula

Underlying profit can be calculated by removing the non-recurring items and other adjustments from the reported profit. Here, reported profits refer to the profits mentioned by the firm in the financial statement.

Non-recurring items are gains and losses that have a chance of a single occurrence in the future. For example, restructuring or reconstructing damages, and others.

Other adjustments can include costs and expenses related to non-operating items.

In some cases, it is possible to calculate the underlying profit before tax. The firms must deduct taxes as a part of the adjustments. Likewise, companies can also perform calculations for underlying profit after tax. The firm must deduct the tax in the statutory reports itself to derive the underlying profit after tax.

Examples

Let us look at the examples of the underlying profits to comprehend the concept better:

Example #1

Suppose ABC Ltd is a firm that engages in the pharmaceutical industry. In the financial year 2022-2023, the firm incurred various non-recurring losses and gains. Following are the adjustments for the year 2022-2023 (in millions):

  1. Sale of a long-term asset (land) = $12.4 million
  2. Restructuring of the corporate building = $1.5 million
  3. Impairment charges = $300,000
  4. Relocation charges = $1 million
  5. Reported profit = $24 million

So, let us look at the calculation of underlying earnings from the reported profits given above:

Underlying Profits   =  Reported Profits - Non-recurring items - Other Adjustments

                                 = $24 million - ($12.4 - $1.5 - $0.3 -$1) - $0 = $24 - $9.6

                                  = $14.4 million

Thus, the underlying profits for ABC Ltd are $14.4 million.

Example #2

A $930 million underlying profit was disclosed in Sun Life Financial's third-quarter 2023 financial results, which were released on November 2023.

The insurer, with its headquarters in Toronto, explained that lower sales of personal health insurance and difficulties in the US market were partly to blame for the 2% decline from the same quarter last year. Although its wealth and asset management section witnessed a 9% gain, Sun Life's US segment reported a 19% fall in underlying earnings.

The wealth and asset management division of Sun Life reported $457 million in underlying earnings, according to the release. Furthermore, the group insurance division had $285 million in underlying net income, up 1% from Q3 2022.

Pros And Cons

Let us look at the advantages and disadvantages of underlying profits.

Pros Cons
Acts as a guide for the investors to understand the company's performance.Various companies may exclude different items based on their point of view.
It states the reasons for possible diversion from the actual profits.They lack standardization as companies will have different formulas.    
Provides a true representation of the company's financials.Chances of manipulation due to no regulation board.
Hence, it is useful for the directors for business planning and investment activity.Companies might ignore some items that may represent a false business overview.

Underlying Profit vs Statutory ProfitĀ 

Although underlying and statutory profits are correlated, they have distinct characteristics. So, let us look at the differences between them:

BasisUnderlying ProfitStatutory Profit
Meaning It refers to the firm's actual profits, neglecting all the one-time gains and losses.Statutory profits are defined as those mentioned in the financial statements per the accounting standards.
Purpose To eliminate certain non-recurring items from the statutory profits to find the firm's accurate profits.  Include all the expenses, gains, and losses during the financial year.
Reporting Standards  A financial standard is mentioned for reporting underlying earnings. It is a non-financial measure.  GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards)
Occurrence Hence, these notes below financial statements, Director or CEO report, financial summary, or a separate section in the annual report.There is a particular page dedicated to displaying statutory profits under financial statements.
Interpretation They represent the actual profits of the company.As various non-recurring and exceptional items are inclusive, manipulation is possible.

Frequently Asked Questions (FAQs)

1. Is underlying earnings the same as EBITDA?

Although both make adjustments to derive a net profit, they have wide differences. Underlying profits are a non-financial metric to determine the actual profits. Here, certain non-recurring items are excluded from reported profits. In contrast, EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization) is a standardized indicator to determine profits. But, in this case, it includes only interest, tax, depreciation, and amortization expenses.

2. What is the difference between underlying profit and underlying loss?

Both are non-financial metrics, but there is a slight difference between them. They have a similar formula for calculating the actual profits, but the underlying loss has a negative answer. So, if the firm's actual profits are lost, it is called an underlying loss.

3. How are operating expenses calculated in underlying profit?

Underlying profits formulas include non-operating and non-recurring expenses in the majority. However, the firm might adjust the operating expenses to derive the underlying earnings in a particular financial year.