Question

Discuss why the past profitability is considered a poor indicator of future profitability. Give examples.

Answer 1

The profitability of a company is a product of several factors like the validity of the particular projects undertaken, the trend in the economy during that particular time, availability of different types of resources like man, tools, and technology, management personnel involved, business and economic cycle, the financial condition of the firm, the competitive ability of peers, systematic and unsystematic risks, economic policies in place, market conditions, etc.

There are several factors pertaining to the firm that can be handled by the company in its operations but the aspects related to the economy, competitors, etc that are beyond the reach of a company can become unfavorable and hamper the growth of the company in the future.
The interest rate in the market might go up which can make it difficult for a company to use leverage for growth, the technology used by a company might become obsolete, the government might bring some regulatory actions on the products sold by the company, the efficient managerial personnel might leave the company, etc. There is always a possibility of things changing for a company making it difficult to replicate the past in the future.

For example, Nokia suddenly went from being one of the market leaders in the mobile industry to a less preferred company due to changes in technology. Same way, Kodak also had to shut down its business due to the changes in trends and technology in the respective industry.

Hence, it can be clearly said that past profitability is a poor indicator of future profitability.