Cooking the Books 2 – The ‘overriding financial objective’
‘Pay ruling “threatens Next stores”’ read a headline in the Times (20 September), reporting on an employment tribunal ruling that women workers in the company’s shops should have been paid the same as men working in its warehouses. Next’s chief executive, Lord Wolfson (the son of the founder), was quoted as saying:
‘Whether we open or close stores will depend on the individual store’s profitability. So you would never expect a retailer to open a store that wasn’t planned to make a profit.’
Knowing how capitalism works, we certainly wouldn’t expect that. In fact, we wouldn’t expect a capitalist enterprise like Next to do anything if it didn’t plan to make a profit from it. As Next put it in this year’s half-yearly report to shareholders:
‘The overriding financial objective of the Group remains the same — the delivery of long term, sustainable growth in Earnings Per Share’ (tinyurl.com/44zkry3h).
In other words, to provide shareholders with a growth in the value of their shareholding. ‘Earnings Per Share’ (EPS) is, basically, profits per share, a company’s after-tax profits divided by the number of its shares. To increase this is the ‘overriding financial objective’ not just of Next but of all companies.
A company’s profit is typically the difference between what it receives from sales less what it costs to run the business. In Next’s case, in the first half of this year its sales (and other) revenue was £2,860m and its costs £2,408m, resulting in a before-tax profit of £452m, which is about 16 percent. This is its ‘profit margin’. It means that for every £ of what Next sells they pocket 16p as profit, the rest going to cover their costs (including wages). After-tax income was £341m, the amount used to calculate EPS.
A company increases the value of its shares by increasing its profits. One way this can be done is by reducing the costs of running the business. This is why Next is so dissatisfied with the legal ruling on equal pay; implementing it will increase their costs and so reduce their profits.
Another way is to increase revenue from sales. As companies don’t normally have control over the prices they charge — they are limited by competition to what the market will bear — the main way to do this is to sell more, to ‘grow’. But the aim is not simply to increase revenue. It is, as Next puts in their report, referring to new areas for growth, ‘to maximise profitable growth’ (their emphasis). The increase in sales must outmatch the cost of bringing this about.
However, not all the profits a company makes are re-invested in growing the business. As Next says in its report:
‘Our established businesses generate more cash than we are able to profitably invest in the Group, so managing our capital to ensure high returns, and returning cash that cannot be profitably invested to shareholders, remains a central discipline of the Group.’
In Next’s case, they invest some of this surplus cash in other companies, the income from which adds to their overall profits. Another part is used to buy back some of its shares which besides distributing money to some shareholders also increases EPS (profit per share) by reducing the number of shares in issue, reducing their supply and so other things being equal pushing up the price. Yet another part is paid to shareholders as dividends. Other companies have a different mix. Some pay no dividends and re-invest all their profits in profitable growth, from which shareholders benefit through the value of their shares going up.
Whatever a company decides to do, the aim is maximise the financial benefit to shareholders. This reflects the logic of capitalism of increasing the value of invested capital (though shareholder capitalism is not the only possible framework for this).