Unmasking the Illusion: Organic Profit vs. Artificial Profit

However, not all profits are created equal. One category of profit, let’s call it organic profit, occurs as a natural result of the company’s effective operations. The company provides its goods and/or services to customers; the customers pay, the company pays expenses in the course of business, and one hopes the cycle continues. Organic profit contributes to building value because it’s more likely to be sustainable and does not attract extraordinary risk.

Contrast this with artificial profit. Artificial profit effectively takes advantage of timing differences to generate short-term profit, typically at the cost of future profit. This results in creating a distorted view of the business’s health and viability, but this isn’t the worst of it. Artificial profit arises from the following practices (this list is not comprehensive.)

Underpricing

In an effort to jumpstart revenue, company executives might boost sales by sacrificing profitability. This approach might be acceptable if profit is still above zero—all companies face margin compression from time to time. However, if the price is so low that the business is unprofitable, it can lower the business’s value as the business is only sustaining itself by tapping into its balance sheet.

Loosening Credit Terms

In many instances, accounting rules allow the recognition of revenue when services are rendered or products shipped. While this accounting rule is sensible, it can be abused. For example, if credit is extended or terms are loosened to dubious customers with the goal of showing book revenue and profit growth, it can make the business appear more valuable in the short term. But ultimately, the profit may be nullified if those customers’ accounts have to be reserved for bad debt, resulting in a negative value adjustment.

Back-Loading Term Payments

The practice of back-loading payments defers the bulk of certain cash expenses until a time when a company is expected to find those payments more affordable. On a cash basis, the company seems more profitable in the short term, but payment becomes due, and the back-end payments could become a significant burden—to the point of negatively altering the company’s risk profile.

Burning Out Staff

Revenue and profitability in the short term can be increased by simply working harder. If the company is operating below its nominal capacity, working harder is a good thing, and the company gains efficiency benefits because that additional effort is sustainable over the long run. However, if the company’s personnel are already operating at (or over) capacity, then additional effort cannot be sustained. At a minimum, people will demand more compensation for working more, eroding profit. Further, sprinting over an extended period of time leads to fatigue, lack of focus, and errors, thereby reducing productivity over time. In not-so-extreme cases, pushing workers too hard for too long results in people quitting. A company with burned-out, demoralized, ineffective labor with increased turnover is quite risky and, therefore, less valuable, even if short-term financial metrics have improved in the immediate term.

Actions taken by a business can only add value to that business if their activities are sustainable. Without sustainability, the short-term benefit is, at best, a windfall, and at worst, can exact such a price that the windfall isn’t worthwhile. It’s the responsibility of leadership to clearly define value-adding performance and contrast it with value-destroying activities.