Before The Measurement Of Lost Profits: Investigating The Business And The Market To “Isolate” The Source Of A Decline

Monday, June 24, 2013 - 11:44

Businesses operate within the confines of a market and industry where the historical financial performance is affected by both internal and external factors and disruptions. General economic conditions, shocks to a specific industry or a locality, changes in the structure of the demand for the goods and/or services, changes in the relationships with suppliers and changes to the cost structure of a business are among the factors that may impact the operations and profitability of a business. Evaluating the reasons why a business may have experienced a decline requires that all these factors be investigated and analyzed. A more telling story about the historical financial performance of a business is revealed when put into the context of its industry, the local economy and the market in which it operates.

Evaluating the profitability of a business is more challenging when legal disputes regarding claims of lost profits arise. There are questions surrounding the nature of the event that “caused” the disruption and the duration of its impact. For example, it may be a straightforward exercise to demonstrate causality when a business loses a contract with a customer for unsafe products that can be traced to tainted ingredients purchased from an approved supplier. While causality is important, developing a lost profits claim requires one to properly evaluate the effects of such event on the financial performance of a business by “isolating” those effects from other factors.

A disruptive event may result in a legal claim of lost profits because of significant negative changes in revenues, costs, compensation of officers (a potentially key cost line item) and ultimately profits. However, establishing that a negative change in profits did occur is not a sufficient basis to establish a 100 percent causality relationship between the disruptive event and a decline in profits. Moreover, measurement of a lost profits claim cannot be based on the decline in profits alone.  

To build a claim, business financial records must be obtained through an effective and timely discovery process. Such data allows for the measurement of a decline in profits resulting from changes in revenues and various cost line items. Conversely, placing the business in the context of its industry and its relevant market requires independent objective research directed toward uncovering key industry-related statistics – information that may be critical in differentiating the impact of economic conditions from the impact of an incident in dispute. Investigating various financial performance measures for the industry in which the business operates provides insight into the expected financial performance during a given period of time.

Analysis of the industry, market and relevant economic conditions must be constructed based on reliable, pertinent information. Information available through various public and private sources regarding a specific industry, overall economic conditions and specific relevant locality(ies) can provide insight into the historical ability of a business to recover from unfavorable economic conditions. Take, for example, a situation in which historical data suggests the recovery from a past, unrelated economic downturn may have taken three years longer for a business under analysis when compared to its industry. Such information can provide a potentially valuable way to establish the expected number of years it would take for a business to recover from a direct incident affecting its operations and profits and the timing of recovery from an external shock unrelated to the incident in dispute. Such investigation and research can assist in the process of establishing the potential damages period in the absence of business-specific information or data that could point to a different time frame. Economic indicators on the industry, relevant market and relevant geographic region can provide a way to measure the portion of a decline in profits that could have been the effect of external forces unrelated to the incident in dispute.

Investigating financial performance of a business goes beyond pure analysis of whether revenues and profits increased or declined or by how much. The significance of critical cost line items relative to total sales is a key analytical tool in evaluating the true financial performance of the business and can provide insight into the business’s ability to perform during economic downturns and to respond to incidents that may directly impact profits. However, the financial relevance of specific line items may only provide limited information if not evaluated vis-à-vis the relevant industry. Information and data regarding the cost structure that is standard for an industry must be independently researched and analyzed before it is used in the estimation of lost profits. Such information can also prove vital in constructing a measure of risk, a key factor for the computation of the present value of potential future lost profits that can be linked to a specific incident.

Josefina V. Tranfa-Abboud, PhD, is a Principal in the Litigation and Corporate Financial Advisory Services Group at Marks Paneth & Shron LLP.

Please email the author at jtabboud@markspaneth.com with questions about this article.