This is the fourth of several articles intended to identify situations in which further questioning of computer-generated financial ratios may be warranted. Within a closely held company's income statement are often a few line items that are to some extent discretionary. The most common of these partially discretionary items is Officers' Compensation. These discretionary items can materially affect a company's bottom line. Figure 1 is a condensed income statement for ABC Company (a retail jewelry store) and the RMA common-size figures found on page 897 of the 2000 - 2001 RMA Annual Statement Studies. ABC Company's pre-tax net income appears to have fallen from $290,000 to $40,000. Secondly, its common-sized pre-tax net income appears to have fallen to 1.0%, which is well the below the RMA industry average of 3.6%. Unfortunately, neither observation is correct. In the above 1999 and 2000 income statements, the only difference between the two years is officers' compensation, which increased significantly--from $250,000 to $500,000. In closely held companies, the ability to adjust owners' compensation can make net income appear to be better or worse than it really is. If the 1999 and 2000 income statements were reversed, would you really want an analyst to conclude that ABC Company's profitability was improving just because the owners took out less in wages? I'm sure the answer to that is "no." A better way to measure a closely held company's profitability is to use the following formula: Net income before taxesOfficers' CompensationDepreciation = Profitability Measure Please note that this formula is not to be confused with traditional cashflow. The traditional cashflow calculation would not include adding back Officers' Compensation and would include adding hack interest expense. The formula for Profitability Measure simply tries to more accurately depict a closely held company's relative profitability when noncash items and officers' compensation are taken into account. If you were going to buy a business and wanted to know the trend in that business's profitability, what would give you the most accurate picture? Would you be willing to pay more for a company whose profitability was increasing solely because the owner was taking less in compensation each year? No, you wouldn't. Applying this formula to the above statements yields Figure 2. This makes it clear that ABC Company was equally profitable in each period. Now the remaining question: "How does one relate this to the RMA common-size numbers?" Most people know that the common-sized income statement appears in the Income Data section of each Statement Studies page, but what one may not have noticed is that the final two ratios on each Statement Studies page are "% Depreciation/Sales" and "% Officers' Comp./Sales." These numbers are, in effect, the breakout of depreciation expense and officers' compensation on a common-sized basis and can be incorporated into the common-size income statement in the Income Data section. Restating Figure 1 on a common-size basis and including the median percentages from the "% Depreciation / Sales" and "% Officers' Comp. / Sales" ratios in the Statement Studies results in Figure 3. Applying the Profitability Measure then yields Figure 4. So what does this tell us? First of all, we find that ABC Company's common-size profitability was the same in 1999 and 2000. Secondly, it tells us that ABC is more profitable on a common-size basis than the median company that is reflected in the Statement Studies. In fact, the conclusion one would draw when comparing ABC Company's common-size profitability to the Statement Studies figures when using the Profitability Measure formula is exactly the opposite of the conclusion one would have drawn regarding profitability if Profitability Measure were not used. The example given in Figure 4, which occurs frequently in closely held companies, demonstrates how misleading just looking at the bottom line of a company to assess its profitability can be. Other misleading situations include overpaying or underpaying rent payments to a related real estate holding company or underpaying or overpaying for inventory from a related company. In these situations, depending upon the objectives of the owner, he or she can make profits improve or decline in either of the related companies. When assessing a company's profitability, particularly a closely held company's, you must keep your eye out for expense items that may have a discretionary aspect to them. If you don't, as the figures in this article demonstrate, you could end up drawing the wrong conclusions.