Dickeson--Don't Be Baffled by Accounting Metaphors
September 2000
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Cash is a fact; profit is an accounting opinion. That short statement says it all. I picked it up recently in a magazine or newspaper. Somebody said it about the Internet dotcom companies and their IPOs. The stock offering brings in megabucks of venture capital. The companies don't make a profit, but who cares? Profit is an opinion of the bean counters. The stock market investors following the IPO bid the stock up higher and higher. But one day the cash runs out and the bubble bursts. Cash is a fact, not an opinion or forecast of future worth. Either you have cash to pay bills and make payrolls or you don't. If you don't…
There are 50,000 printing companies, and if the shops that report to the PIA ratio studies are typical, printers average 3 percent to 4 percent "profit" on sales. That's dreadful, we moan. We ought to be ashamed, we say. But wait a minute. If our shop were a dotcom, we'd be in fat city with 4 percent on sales. If we were reporting 10 percent on sales, but it was all tied up in inventories and receivables and we couldn't make payroll, we'd be in hot slop. Now if we were a grocery supermarket, 2 percent profit on sales might look just dandy—if that 2 percent were cash in a money market account. Look at the "ecology"—the total environment—of profit or residual value.
What the dotcoms have done recently is signal a reality check. Profit is an accounting "opinion." It's based on a whole fabric of critical assumptions, many of which are charming archeological artifacts. Here are a few:
And so on. Accounting, and its handmaiden profitability, are metaphors, a form of virtual reality. No one, including investors and the IRS, believes accounting profits or book values except when it's expedient, convenient or self-serving to do so. In computing a price-earnings ratio to value a business, what, for example, are "trailing earnings" compared with "profitability?" What does that "EBITDA" gibberish mean when looking at price earnings multiples? It means stripping away some of the opinion assumptions of "profit."
There are 50,000 printing companies, and if the shops that report to the PIA ratio studies are typical, printers average 3 percent to 4 percent "profit" on sales. That's dreadful, we moan. We ought to be ashamed, we say. But wait a minute. If our shop were a dotcom, we'd be in fat city with 4 percent on sales. If we were reporting 10 percent on sales, but it was all tied up in inventories and receivables and we couldn't make payroll, we'd be in hot slop. Now if we were a grocery supermarket, 2 percent profit on sales might look just dandy—if that 2 percent were cash in a money market account. Look at the "ecology"—the total environment—of profit or residual value.
What the dotcoms have done recently is signal a reality check. Profit is an accounting "opinion." It's based on a whole fabric of critical assumptions, many of which are charming archeological artifacts. Here are a few:
- Inflation is zero over time: buildings and equipment purchased with the dollars of an earlier day still have the same depreciable value today;
- Land does not change in value over time;
- Leases negotiated in past dollars and at some historic interest factor are equivalent today and tomorrow;
- A "going concern" cannot be assigned value; and
- Inventories are valued at the lower of cost (regardless of inflation) or market.
And so on. Accounting, and its handmaiden profitability, are metaphors, a form of virtual reality. No one, including investors and the IRS, believes accounting profits or book values except when it's expedient, convenient or self-serving to do so. In computing a price-earnings ratio to value a business, what, for example, are "trailing earnings" compared with "profitability?" What does that "EBITDA" gibberish mean when looking at price earnings multiples? It means stripping away some of the opinion assumptions of "profit."
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