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Who cares about profits?

June 18, 2011

Some years ago the senior credit officer in the division where I worked asked me to review a loan to be proposed by my direct superior.  The loan was to a second-generation, family-owned, middle-market company.

I remember commenting to my boss, ‘Mark (names have been changed to protect the guilty), this company doesn’t really make money, and hasn’t for as far back as we have financial statements.’  I also remember the response, ‘Fritz, it doesn’t matter.  Giovanni is in love with his business.’  Only someone comfortably employed by a large public firm would be capable of a statement like that!

While the company did make a small amount of money on an accounting basis, its returns had long been dismal by almost any measure.  The loan proposed would be well-secured by assets.  Repayment at 365 days was not in doubt. Still, the loan was not approved. The committee found no evidence to suggest a happy future for the company.

Lending officers are right to focus on repayment capacity and security, but they also need to consider a firm’s underlying profitability; profitability as measured by return on sales (ROS), return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC).

I recognize that these profitability measures are important although far from perfect.  ROE, for example, does not factor in risk from leverage (either operating or financial) or from volatility.  It can also be affected by assets whose values are significantly understated, as is often the case in second or third generation family businesses.  Used intelligently, however, ROE and other measures can point to situations where insufficient economic return is eroding shareholder wealth.

Measuring the cost of equity for a family-controlled, middle-market company is also difficult.  However, if year-after-year a company pays 6% for access to well-secured bank loans while its shareholders earn only 2%, it is a good bet that it is not earning its cost of equity.

Does insufficient economic return really matter?  Of course it does. There is the obvious erosion of economic equity, but perhaps worse, there are unhappy, and at times desperate, owners and managers.  In my own unscientific studies, I have noticed a correlation between the improper and speculative use of derivative instruments and middle-market firms whose basic businesses were not generating sufficient economic return.

As important and as obvious as this seems, many bank officers do not give real economic profitability the attention that it deserves.  In the classroom reviewing case studies with bankers, I often pose the question, ‘Is this company really profitable?’  Missing the point, participants often answer referring to the profitability of the bank’s relationship with the customer and not to the client’s own profitability.  A profitable banking relationship with a company can only last as long as the company stays profitable, creates value and, ultimately, stays in business.

by Fritz Newman

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