Why do most companies make losses?

Conference Presentation: Why do most companies make losses?

Myddelton, David

Professor Myddelton gave this presentation to the EBEA’s annual conference in Manchester on 21st March 2005. Nancy Wall transcribed it.

I shall approach the question ‘Why do most companies make losses?’ from three different angles: accounting; managers’ motivation, and the nature of competitive business.

(A) ACCOUNTING

Let me start with accounting. We can define ‘profit’ as gross income less total expenses, and ‘losses’ either as negative profits or as total expenses less gross income. There are four accounting aspects I want to explore, all suggesting that expenses may often be understated. That means that many companies reporting accounting profits may in reality be making ‘economic’ losses.

(1) First, inflation can have a big effect. We nearly always use money as the accounting unit of measurement, but in times of inflation that can produce inaccurate results. In principle I believe we should be accounting in terms of constant purchasing; and in Victorian times, when modern accounting was being developed, the two were synonymous. Year after year there was virtually no inflation, so money itself represented ‘constant purchasing power’. How very different from the reign of our own dear Queen! Since I started teaching in 1965 the £ has lost more than 90% of its purchasing power.

The inflation rate now is much lower than in the 1970s when, at its peak, inflation was running at 25% a year. So it is almost universally ignored in accounting these days. But even today’s rate of about 3% a year mounts up over time: compound interest is a marvellous thing! Suppose a business uses equipment with a 15 year life, which it depreciates on the straight-line basis. If inflation averages 3% a year, that means the business will be understating its depreciation charge every year by about 25%! [Note 1] Since the difference is not tax-deductible, that has to come out of after-tax profits.

Take a company like the BOC Group plc (British Oxygen). Its profit after tax in 2003 was reported as £300 million after charging depreciation of £320m. The life of its tangible fixed assets averages roughly 15 years. So I say the depreciation charge, properly adjusted for inflation, ought to have been about 25% (£80m) higher; which would reduce BOC’s profit from £300m to £220m.

That seems surprisingly high, at a time when we casually talk as if inflation is no longer a problem. (The impact is relatively large due to the cumulative impact of inflation at 3% a year over the asset life of 15 years.) At least it reminds us that accounts can be subject to significant margins of error. The impact on BOC’s reported profit may not be typical. And I’ve ignored some other less striking aspects of inflation.

(2) The next aspect of profits I want to mention is the possibility that many smaller companies may not charge a realistic amount for their owner-manager’s wages. (This may also be true of sole traders and partnerships, where the ‘profit’ includes proprietors’ wages. Such unincorporated businesses usually don’t charge any tax either, since ‘profits’ are taxable as the proprietors’ personal income.) Owner-managers may often prefer to work for themselves, but that doesn’t mean it’s profitable. Hence such businesses can report apparently adequate profits which may become totally inadequate after making a realistic charge for the opportunity cost of their owners’ services.

(3) Another accounting reason for companies overstating profits is failure to charge amortisation of purchased goodwill. This is a controversial topic. My own view is that it’s necessary to depreciate the purchase price of goodwill arising on acquisitions in order to show whether the acquiring company has made a profit from the point of view of its own shareholders. That is not now the practice in the US or in International Accounting Standards – which from this year listed companies in the European Union (including in the UK) are having to follow.

The numbers can be big: for instance when Glaxo purchased SmithKlineBeecham the deal was treated as a merger. Had it been treated as an acquisition, GSK – the new group – would have had to charge £750 million against after-tax profits for each of the next ten years. That would certainly knock a bit of a hole in the reported profits!

You sometimes hear analysts talking about EBITDA – Earnings Before Interest Tax Depreciation and Amortisation. I think this is a highly suspect way of looking at business results, as it deliberately omits several perfectly legitimate and necessary business expenses, in particular amortisation of goodwill.

(4) Finally, and most important, is the opportunity cost of equity capital employed in the business. Over the years, there have been a number of accounting changes designed to bring accounting profits more closely into line with economic profits. An obvious example is the treatment of finance leases. But this has never been extended to the cost of equity capital.

This notion leads to what used to be called ‘Residual Income’, and is now sometimes referred to as Economic Value Added, or EVA. The idea is widely used in Management Accounting (or internal accounting). But it has never, as far as I know, been used on any systematic basis in Financial Accounting (or external accounting).

Debt interest does appear as an expense in ordinary profit and loss accounts. So the only adjustment that is needed in respect of ‘interest on capital’ is to deduct the notional cost of equity capital from reported after-tax profits. Measuring this amount is difficult. There are two problems: what is a company’s ‘cost of equity capital’? And what is the amount of capital to which it should be related? If you use balance sheet book values you’re on thin ice, though the book value of shareholders’ funds may often understate the economic reality.

My own view is that a real (not nominal) cost of equity capital for many companies is probably of the order of 10% a year. I arrive at this conveniently round number by adding to a real risk-free rate of 2% an assumed average equity risk premium of 8%.

The real risk-free rate of 2% a year is not controversial. One can think of it as the yield on index-linked government securities. Because they’re government securities they’re regarded as risk-free; and because they’re index-linked, they’re in real terms.

The appropriate level of the equity (or ‘market’) risk premium is arguable. Most academics reckon it ought to be around 8% a year. That’s my opinion too. But some people in the securities industry, who may have a vested interest in getting people to think shares are cheap, say it should be much lower, maybe around 2% or 3%.

Let me again use BOC as an example. I reduced its profit after tax from £300m to £220m by allowing for a depreciation undercharge of £80m. What would happen if we now also charged against profit after tax a notional 10% cost of equity capital?

Shareholders’ equity in BOC’s balance sheet amounts to about £1,900m; but we ought to add back nearly £200m goodwill written off directly against reserves. I’m arguing that to get to real economic profit we need to charge against after-tax profit an annual 10% cost of equity capital, namely £210m. That leaves BOC making a real profit for its shareholders in 2003 of just £10m!

With about 500m shares in issue, that gives us earnings per share of only 2 pence! So BOC’s current share price of just about £10 implies a real price/earnings multiple of 500! (And amortising the goodwill we’ve just added back would completely wipe out the ‘remaining’ £10m profit and suggest that BOC itself was making a ‘real’ loss!)

I happened to have BOC’s accounts to hand, so let me remind you that BOC may not be typical. And the estimates I’ve been discussing are very rough. But charging the cost of equity capital at a real 10% a year on the book value of shareholders’ equity makes a big difference. Indeed on this basis even some large companies may be making economic losses rather than the profits they’re reporting. Not to mention many smaller companies.

(B) MOTIVATION OF MANAGERS

The second general reason why profit-seeking companies may often make losses stems from corporate finance. ‘Agency theory’ deals with the question: how can the owners try to ensure that the managers of a business, their hired servants, act in the interests of shareholders? Shareholders normally want their company to ‘maximise profits’, so under what circumstances might managers not want that or, at any rate, fail to achieve it? I suggest that in a number of areas managers might be tempted to get involved in activities that result not in profits but in losses. Of course this aspect of corporate finance concerns listed companies, owned by diversified shareholders but actually run by professional managers, who usually themselves own only a tiny proportion of the shares.

(1) Acquisitions. There seems to be general agreement that many acquisitions ‘fail’ – at least from the point of view of shareholders in the acquiring company. (Shareholders in companies being acquired often do rather well!) That’s partly because all too often managers’ egos, rather than commercial logic, dictate acquisitions.

(a) Sometimes too big a premium is paid, which is never compensated by sufficient postacquisition earnings. Marconi’s folly in borrowing cash to pay huge premiums for overpriced hi-tech US acquisitions is perhaps the best-known recent example.

(b) Sometimes it proves very difficult to merge companies with different cultures. I suspect that William Morrison is having trouble with Safeways on this account.

(c) Sometimes managers get into ‘conglomerate’ mode, in order to reduce the total risk of their business, and thus start acquiring businesses in industries they really know very little about. The result can easily be huge losses. At one time, cigarette company managers were keen on this. Modern portfolio theory says that instead managers ought to be concerned only with what is called ‘nondiversifiable’ risk – on the assumption that most shareholders will already hold diversified portfolios.

(d) Sometimes managers fancy building up multinational empires, and get involved in countries about which they know very little but to which it’s rather fun to travel. Frank Knight says people want an ‘interesting’ life. Managers may, but on the whole shareholders don’t. Like Warren Buffett, they’re content with a fairly boring life, as long as it’s highly profitable.

(2) A related area has to do with size. Managers often seem to think bigger is better.

(a) One obvious reason is that managers’ pay tends to be related to size.

(b) Aiming for market share sometimes means increasing sales without increasing profit. The old Japanese approach was said to be: first build up your market share, then wipe out competition and start reaping huge profits. But many companies don’t progress beyond Stage 1. They ‘buy’ market share but never quite get to the huge profits!

(c) Another example is dividend policy. The key question is, who can use the money best: the company or the shareholders? Michael Jensen suggests that often managers choose to retain too much profit in the business, in order to give themselves discretionary elbow-room, and then fritter away shareholders’ money on various unprofitable schemes. (So he favours high debt ratios, to pre-empt a large percentage of companies’ operating cash flow and precisely to limit managers discretion!)

(C) THE NATURE OF COMPETITIVE BUSINESS

Now finally, and very briefly, let me come to perhaps the most obvious reason why many profit- seeking companies actually make losses. It isn’t so easy to make a profit!

It’s not easy to identify precisely what people are going to want to buy, and to get most, if not all, aspects of the marketing right: such as the product itself, the packaging, and the price. It’s thought that at least 90% of new products fail.

In arranging the production of tangible goods, an awful lot can go wrong: the materials, the workers, aspects of delivery. The same applies to service businesses. And identifying product costs is something many companies get wrong.

The fact is the future is uncertain, and it’s not easy to maintain enough flexibility and elbow room to allow for that, as well as constantly keeping alert to spot when trends are beginning to change. And I haven’t even mentioned competition, which is continually trying to frustrate your own efforts. Nor government regulation, which can easily destroy your business’s profitability.

LET ME SUMMARISE MY MESSAGE.

There are several different reasons why profit-seeking enterprises might actually make losses, and I’ve discussed three general categories.

The first is accounting: failing to allow for inflation; unincorporated businesses failing to charge a realistic salary for the owner-manager; failing to amortise purchased goodwill; and finally, failing to charge interest on equity capital. As a result of all this, many businesses that are reporting accounting profits may actually be making economic losses.

I must admit I don’t have any hard evidence to tell us whether more than half of all companies actually make economic losses or not. And it wouldn’t be easy to get it. My guess is that they do, after the adjustments I’ve referred to. But it is only a guess.

The second set of reasons stems from corporate finance and the motivation of managers: in acquisitions, managers may be tempted to pay too much in a battle of egos; they tend to value size for its own sake; and they may (unlike diversified shareholders) be concerned with total risk, hence overly keen to get into industries or regions they know little about in an economically superfluous attempt to diversify.

The third set of reasons has to do with the nature of competitive business. It’s not easy to cope with all the marketing, production, finance and other problems of running a business enterprise profitably, especially in the face of competition and governments. The future is uncertain, which means that the best-laid plans often go wrong. Sometimes, by the way, this may be simply as a result of bad luck. Luck is important in business, both for good and ill.

Is there any great educational implication in all this? If I’m right, perhaps more of our examples should be concerned with things that go wrong, rather than sometimes seeming to imply that the normal result of business is profit. I think that’s too optimistic (one might say, ‘unrealistic’) a picture.

NOTE

1. Explained in D.R. Myddelton: ‘On A Cloth Untrue: inflation accounting, the way forward’ (Woodhead-Faulkner, 1984), Appendix, pp. 123/4.

David Myddelton is President of the EBEA and Professor of Finance and Accounting at the Cranfield School of Management.

Copyright Economics and Business Education Association Summer 2005

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