Why Profitability is Important

Investors as famous as Warren Buffet have dismissed profitability, as measured by EBITDA, as a suitable corporate financial metric, favoring “Owner’s Earnings” or Operating Cash Flow instead.  Given Mr Buffet’s record of success, it is hard to argue the point . . . on its surface.  Scratch that surface, however, and profitability shines as a critical component of both of his preferred financial measures.  

Profitability is important.

First, some background.  Some twenty years ago, Warren Buffet told his Berkshire Hathaway shareholders:

“When Charlie (Munger) and I read reports, we have no interest in pictures of personnel, plants, or products. References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures?

He has repeated this point many times since. Using a simple multiple of EBIT or EBITDA to value a business can be shortsighted.  Also, let’s not forget that GAAP standards are flexible, allowing for significant interpretation of accounting provisions and methods.  Profits can be manipulated.  Corporate executives, hoping to achieve profit-based financial incentives, have been known to seek out one-time gains, or to shift expenses between reporting periods. These and other, profit boosting maneuvers are difficult to detect.   

So, yes, profitability can be a poor yardstick to use when evaluating large corporations.  For small businesses, profitability remains very important.  Looking for a bank loan?  A three-year trend of profitability is often a prerequisite.  Seeking outside investment?  You’ll find it difficult if your business cannot demonstrate a likelihood of strong, long-term profitability.  Hoping for a raise or, perhaps, a dividend?  Profits are key. 

So, what exactly is profitability?  At its most basic level, profitability arises when aggregate revenues are greater than aggregate expenses in a given reporting period.  Net profits.  Yet, profitability is so much more than just this “bottom line.”  Focusing only on net profits is akin to skipping to the final chapter of a mystery novel.  You reach the denouement but have little idea how you got there. 

Follow my next blog, where I evaluate one of the basic building blocks of profitability.  I’ll deep-dive into Gross Profits (Net Revenues minus Cost of Goods Sold).  Far too many businesses focus on just one “half” of this calculation, Cost of Goods Sold.  I’ll elaborate on why more attention must be paid to pricing.  One-dimensional, simplistic pricing policies not only reduce your business’s profitability, they limit its growth as well.