Strengths and Weaknesses of Economic Profit:
The map metrics above helps to understand that economic profit it is one of several valid performance measures, each of which offer a different type of insight into a company. Finally the following strengths and weaknesses are reported in order to consider whether economic profit is an appropriate performance metric for the company one is evaluating:
Economic profit’s strengths include the following:
1. If one had to rely on only one single performance number, economic profit is probably the best because it contains so much information (mathematicians would call it “elegant”): economic profit incorporates balance sheet data into an adjusted income statement metric.
2. Economic profit works best for companies whose tangible assets (assets on the balance sheet) correlate with the market value of assets – as is often the case with mature industrial companies.
3. Because it is a residual performance metric, it conveniently summarises into a single statistic the value created above and beyond all financial obligations.
4. By applying a capital charge, it corrects the key deficiency or earnings and earnings per share (EPS): they do not incorporate the balance sheet. Economic profit explicitly recognizes – by way of the capital charge – that capital is not free and, if growth is purchased with capital, economic profit recognizes that the growth is not free and assigns a charge for the capital used to purchase the growth.
5. As an operational metric, it helps managers clarify how they create value. Generally, they do it either by investing additional capital that produces returns above WACC, by reducing capital employed in a business, by improving returns by growing revenues or reducing expenses or by reducing the cost of capital.
Economic profit’s weaknesses include the following:
1. Unless fully loaded and all cash adjustments are made, economic profit can be subject to accrual distortions. For example, because NOPAT is after depreciation and amortization, a company that does not reinvest capital to maintain its plant and equipment can improve its accrual bottom line simply by virtue of the boosting economic profit is known as harvesting the assets.
2. It has the limitations of any single-period, historical metric: last year’s economic profit will not necessarily give you an insight into future performance. This can be especially true if a company is in a turnaround situation or makes a large lump-sum investment, in which case, economic profit will immediately suffer (due to the higher invested capital base) but the expected future period payoff will not show up as a benefit in the calculation.
3. Any value obtained by employees of the company or by producer users is not included in the calculations.
4. Although some proponents argue economic profit is “all you need”, it is very risky to depend on a single metric.
5. The companies least suited for economic profit are high-growth, new-economy and high technology companies, for whom assets are ‘off balance sheet’ or intangible.
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