# Why don't profitable firms use previous profits to offset current loss

It is being reported that EasyJet expects a heavy loss in the current year due to Covid-19 pandemic. The report states that

The airline said it expected to sink into a pre-tax loss of between £815m and £845m in the current financial year, which is worse than analysts' forecasts of a £794m loss. It would be the first time in EasyJet's 25-year history it has not made an annual profit.

The report also says that EasyJet has laid off more than 4000 people and has taken a government loan.

I looked at their profit profile and it looks like they have made more than 300 Million pounds profit for last many years.

Why can't they offset the loss (caused by special case) from their earlier profits rather than resort to drastic job cuts and government bailout?

• Just having profits in the past doesn't mean it's still there on the books in form of cash. It may be just gone now: in dividends or by investment in fixed capital. – Dayne Oct 9 '20 at 1:43
• If Easyjet is "just an example", it is not a very good one, as their move is reasonable, not panic: demand for air traffic is not likely to fully recover in the near future. Rather than perform a major edit in this question, please consider posting a new question were you clearly specify your interest and also support your claim with some sources. Did Apple "panic at first sight of loss"? – Giskard Oct 9 '20 at 7:45
• @Giskard Noted and I have rolled back the edit. I now understand that profits may not be available as cash with the firm and their behaviour is similar to how we expect people to behave (Not everyone saves for a rainy day and when squeeze comes you chop the most 'unnecessary' expenses) – RedBaron Oct 9 '20 at 9:16
• Profits are measured in a given time period. If it was measured properly in a previous period then there is no reason to change what was already decided. What you are really asking about is resources or specifically financial resources or more specifically money. – H2ONaCl Oct 14 '20 at 19:20

The primary goal of most companies is to make money for its shareholders. They put money in, and they expect to either get dividends, or be able to resell their shares for a higher amount. It's the shareholders who own the company, and they are the ones deciding. And they want money. Otherwise they would give their money to charity.

So when a company makes a profit, they will do a combination of one or more of these:

• Set aside some as reserves (in some cases there are mandatory reserves by law)
• Re-invest some of the profit to make more money in the future (buy new equipment, buy companies, hire people, send money on R&D...)
• Pay dividends to shareholders, or buy back shares (two ways of giving money back to shareholders)
• And the rest will remain as cash.

Investors usually don't want the company to hoard profits. A safe reserve so it can go through difficulties, but that's it. Cash in the bank makes very little money, it's not a useful use of those funds for the investor: they'd rather get the money and invest it themselves according to their own risk profile.

If the company doesn't do what the investors want, then the shareholders will usually change management to make sure it complies.

So keeping employees on the payroll in tough times is not a primary goal of most companies. Of course, it's not a good idea to fire everybody at the first sign of trouble (it has an impact on the morale and performance of the other employees, it may cost a lot in severance, and when business picks up it will take time and cost money to hire and train new people), but if things are too bad, then it's the only option the company has to fulfil its obligation to shareholders.

There may be exceptions: a company and its shareholders may decide that their social responsibility is more important than making money. Cue all the "fair", "equitable", "social", "responsible", etc. keywords. But those are really the exception rather than the norm, and there's a limit to what can be done. Even if it made profits consistently and kept those as reserves, those reserves can't last forever while the company is burning through cash.

Remember that many companies have very small profits compared to the revenue and costs.

Consider a company with usual revenue of 1 billion pounds, but with tight margins: their expenses could be 900 million pounds, so the profit is 100 million pounds. They keep the profit year after year for 5 years, so they now have 500 million pounds in the bank, and the shareholders haven't complained yet (as if).

Now Covid strikes, and the revenue dwindles to 100 million pounds. If they keep all their costs the same, they're haemorrhaging 800 million pounds a year. They won't last a year like that! So yes, they will have to reduce costs, and part of this is laying off staff.

Don't think those figures are realistic? In 2019, Easyjet has revenue of about 6.385 billion pounds, but expenses of over 6 billion pounds! With revenue slashed to a fraction of what it was, they obviously can't keep spending like they did. They would have needed to keep profits of the last 20 years just to be able to get through this year.

• I hadn't thought about costs >>> profits . +1 for simple explanation. – RedBaron Oct 9 '20 at 11:00
• What's the difference between "reserves" and "cash"? Are reserves just cash that you don't plan on using unless there's an emergency? – Barmar Oct 9 '20 at 14:20
• @Barmar that's probably better asked as a separate question; a short answer is that various types of reserves are legally restricted for specific usages in contrast to cash that can be spent when/how the company considers most valuable. At least in some cases it's not "cash that you don't plan on using" but rather cash which it would be illegal to use for another purpose. – Peteris Oct 9 '20 at 15:33
• I asked it as a comment because you listed them as separate bullet items in your answer, without distinguishing them. – Barmar Oct 9 '20 at 15:35
• A 10% profit margin is excellent in many lines of business. "Tight margins" are those of grocery stores, often around 2%. – chrylis -cautiouslyoptimistic- Oct 11 '20 at 3:02

Specific case of EasyJet

It is impossible to answer whether EasyJet in particular could do something different, without some detailed case study. Just stating that the firm was profitable in past is not enough information to say anything in this situation. Profits are routinely paid out as dividends to shareholders or reinvested in the company (we dont know if they set up any large rainy day fund). Furthermore, optimal decisions depend more on what happens now and what firm believes will happen in future.

Why don't profitable firms use previous profits to offset current loss?

This is because such course of action might simply not be rational or optimal for firm to do. Consider a simple example of firm A, and lets model this firm as a monopoly (I know this is not accurate as EasyJet is competitive firm but it simplifies math tremendously and does not affect the point I am going to make).

Lets suppose this firm A faced at time $$t$$ following demand: $$P=100-2Q$$, where $$P$$ is price and $$Q$$ quantity, and had following total costs: $$TC=2Q^2+400$$. Given these assumptions the profit function of the firm will be:

$$\Pi = (100-2Q)Q - 2Q^2-400$$

Now if we reasonably assume firm is profit seeking it will choose $$Q$$ that will maximize its profit and hence:

$$\frac{d \Pi}{dQ} = 100-4Q - 4Q = 0 \implies Q^*= 12,5 \implies P^*= 75 \implies\Pi^*= 487.5$$

So we see that at time $$t$$ the firm earns profit $$487.5$$ and produces $$Q=12,5$$ (and the number of people they employ depends on $$Q$$).

Now let us suppose that in time $$t+1$$ unexpected pandemic hits shifting the demand to the left by reducing the quantity demanded at any price by 80 making the new demand: $$20-Q$$. What will the firm do now? Now it's profit function will be:

$$\Pi = (20-2Q)Q - 4Q-400 \implies Q^* =2.5 \implies P^* = 17.5 \implies \Pi = -366.25$$

So as you can see from the heavily stylized example above when situation changes firm behavior changes. In this case due to fall in demand the quantity produced will be lower (and assuming their production function is lets say $$Q=L$$ where $$L$$ is labor their number of employees will be cut). The fact that in past firm recorded profit that is in excess of current loss is irrelevant for optimal behavior.

On bailouts

A bailouts of such firms are often criticized by economists (see some discussion in undergraduate textbooks such as Mankiw Principles of Economics), however note your question does not ask if the bailout is optimal to society. You ask why should the company resort to getting bailout? Well the answer is simple: Because it can get one. From perspective of private company bailout is almost as good as free mana falling from the heaven.

I can't imagine company directors explaining their shareholders that they refused free money from government because in past they were profitable. Regardless of whether its optimal for society or not (or if it is ethical) from a perspective of a company I would even dare to say if a director would not accept bailout (assuming no strings attached - as if its conditional on some bad decision for company it might be better to refuse it) it would be an incompetent act.

• Just to add to your second section, there is a more subtle point in play, I believe. It is true that past profit is irrelevant for optimal behavior in that framework. However, that is only because you assume a static (or effectively static) setting. In a dynamic case it may be relevant (without a 100% bailout guarantee). But we typically assume in the scientific literature that is not possible for firms to credibly commit to a sequence of strategies. Then, for the firms, the optimal solution is equivalent to a static problem in each period. But that's not necessarily always a given. – BB King Oct 8 '20 at 16:03
• @BBKing yes you are of course completely right, although as far as I understand even in dynamic setting it matters for decisions ex-ante not once the decision becomes past (unless we formulate some sort of adaptive expectations). – 1muflon1 Oct 8 '20 at 16:11
• Of course. But I'd argue the more interesting problem is from the perspective of the period in which you have and can actually save profits for the future. Of course, the past is the past. Trivially, the answer to "Why can't EasyJet use past profits that they did not save" is "Because they did not save them". The more relevant question is "Why did they not save them?". – BB King Oct 8 '20 at 17:03
• @BBKing In this specific case, one might argue that the shock is exogenous, and large enough that any consumption-smoothing/precautionary saving attempt (if the airline industry is predisposed to such practices, which I kinda doubt) is not relevant. – Michael Oct 9 '20 at 8:21
• +1. This beats the currently accepted answer, by noting that even if the liquidity is available to continue operations at full steam, it is optimal for a company to shrink in a downturn. Another phrase that could be used: Past profits are sunk gains. The right-sizing decision is about future profits and losses, not past ones. – nanoman Oct 10 '20 at 9:25

It might make sense to cut the jobs as it looks like they will be operating at reduced capacity.

The article does not say that they could not keep on the workers and "smooth" their yearly losses and profits but merely that they choose not to do this.

Government bailouts in similar situations have been critized for the reasons that you state: it might incentivize insufficient saving in good years, thereby creating a problem of moral hazard.

• Just to add, another important point is that it is very difficult (if not impossible) for the government to credibly commit to no bailouts. This causes an implicit bailout guarantee even if a few bailouts here and there don't happen, since the decision for bailout is made after the decision to not save. This became especially clear in 2008 with Bear Stearns. – BB King Oct 8 '20 at 19:43

Overall profits are irrelevant to layoffs. What matters are marginal profits from employees. If the marginal profit from retaining employees is negative, then employees should be laid off. Similarly, whether a loan should be taken depends only on the marginal profit from taking that loan.

It's really not clear what you mean by "offsetting" losses with previous profits. It seems to be based on a deeply flawed understanding of finance.

I think an important point of view for this question is also from financial side:

1. The profit made in previous years may not necessarily accessible for the company in form of cash or other assets. In most likelihood it may have been distributed to shareholders as dividend. If it were accessible, the company would be cash rich and may very well would have not resorted to such measures to survive the storm.

2. The problem company is facing is that of cash balance. Not enough cash flows to sustain their operations. Hence the measures such as to cut jobs to control cash outflow.

3. So what you need is capital infusion. If the company is listed, they can go for a fresh public offering to raise more capital. However, the markets are not really in the mood of taking risk of investing in stocks of underperforming firms. The share value must already have hit rock bottom, few new or existing investors would be interested in buying more of these. Another option is to liquidate assets to get cash to tide over current fixed expenses.

4. As very nicely alluded to in comments by @BBking, if the objective is to survive (maximizing present value of future profits - dynamic profit maximization) and there is a good probability that govt will bailout or loan them money at cheap rates, then it makes sense to not liquidate assets and use govt's cash to ride out the storm. It also makes sense for the govt to do so as it protects savings of so many retail investors.

This is applicable for all such companies whose business is temporary affected by covid. In permanent damage the impact usually unfolds slowly. But in anycase that would a very different scenario.

Why can't they offset the loss (caused by special case) from their earlier profits rather than resort to drastic job cuts and government bailout?

There are several reasons:

• History is already past, decisions are made to handle now and the future.
• The limiting factor is not really the profits but cash (generally called with a more fancy name as liquid assets). There will be an outflow of cash for salaries and other costs. If previous profits are not "saved in the bank" the company will have to borrow more money somewhere.
• The company will consider the requiered cash as an investment, especially if it is borrowed money. And as there are always alternative ways to invest money -- is keeping the full work force the best possible investment or is it a better investment to downsize now and possibly upsize later?
• Time is an important factor. Will the current problems be resolved next week or in five years? Nobody knows for sure, but time will be part of the investment decision.

Why can't they offset the loss (caused by special case) from their earlier profits rather than resort to drastic job cuts and government bailout?

That doesn't really mean anything. They had those profits in the past. They had those losses this year. Those are facts. What does it mean to use one to offset the other exactly?

As a general rule, what you should do once you get to a particular place does not depend on how you got to that place. Whether it makes sense to cut jobs or take loans depends on only two things: where the company is now and what the company thinks its future prospects are. Which decision is better for the company's future is in no way dependent on how profitable the company was in the past.

Generally speaking, companies don't hold onto a bunch of cash. Doing so is risky and inefficient. If you (as a company's board) hold onto too much cash instead of paying it back as dividends, your investors can get upset to the point where they replace the board with someone who will pay dividends.

There's also a big opportunity cost. Money in the bank just sits there, maybe earning a tiny amount of interest. Money invested back into the company (upgrading facilities, funding new projects, etc), on the other hand, increases the company's earnings potential and value.

If the company is publicly traded, there's also a takeover strategy where a large war chest can be used against you. I can't locate a well-written description of the strategy, but here's an oversimplified layman's summary. A company's value (and by extension, its stock price) is based on its expected future earnings, not by how much cash it has. Say your company is worth \$10M. You have a good quarter and earn \$1M, which you put in savings. I can borrow \$1M from a bank, combine that with my own money, and do a hostile takeover of your company. Once I take it over, I can use that \$1M in the bank to pay back the loan. I just bought your company at a discount by using your own savings against you.

For reasons like these, the profits earned by a company aren't held for very long. They'll get periodically distributed as dividends to shareholders or re-invested into the company. They might keep a little bit on hand for emergencies, but typically not enough to pay expenses like payroll over an extended period of time.

Companies tend to rely on debt instruments like lines of credit for financing things instead of war chests. A line of credit costs practically nothing when you're not using it. When you are using it you have to pay interest, but that additional interest is less than the increase in earnings you can achieve by reinvesting your earnings into the company. The downside, of course, is that there's always a limit to what you can borrow. Sometimes governments step in and help companies to keep them afloat when they can't borrow any more money through traditional means. This is frequently called a bailout, even though in most cases it's structured as a loan and the company is required to pay it back over time with interest.

In cases like EasyJet, companies tend to lay off employees to reduce costs instead of borrowing money to make payroll. For them, customer demand is way down so fewer employees are needed in the first place. It's easier to lay off some of your employees and then hire them back once demand picks back up. That's not always what happens, though. Some companies aren't seeing that lack of demand and for them, losing personnel can mean that they can't meet customer demand, can't fulfill existing contracts, etc. In those cases, the company may actually lose less money by borrowing money to meet payroll expenses.

As I heard from Peter Thiel few years ago that Airline industries runs at 97% operational cost, which means they hardly makes any profits.

Now what about Richard Branson and other airline companies, well at this time they are struggling to keep their airline running.

In order to survive they are to doing these things:

• Lay-off employees
• Cut salaries
• Seek out for investments
• Seduce their customers to fly in their plane
• Take loans

If accounting rules allow firms to report part of their losses on financial statements of the following years, in this case, yes Easy-jet would have an incentive to report a part of its loss at period $$t$$ on future years. In the case where the profit rate is $$\tau ,$$ and with only two periods, the after-tax profit over both periods, with no reporting possibility, is given by $$\left( 1-\tau \right) \max \left\{ 0,\pi _{t}\right\} +\left( 1-\tau \right) \max \left\{ 0,\pi _{t+1}\right\}.$$ If a part $$\alpha$$ of the loss at $$t$$ can be reported to next year, then the after-tax profit is: $$\left( 1-\tau \right) \max \left\{ 0,\left( 1-\alpha \right) \pi _{t}\right\} +\left( 1-\tau \right) \max \left\{ 0,\pi _{t+1}+\alpha \pi _{t}\right\}.$$ Tax paid in the later case are lower as in the former situation. As tax revenues are also smaller, it is not clear whether the State has an incentive to implement such a profit shifting rule -- unless employment (which varies less in the later case) is also taken into account.

It is unfortunately difficult to answer your question more precisely, as we are less informed about the actual accounting rules than Easyjet, which is aware of its "continual need to keep well informed and adapt (as required) to any legislative or regulatory changes across the jurisdictions in which easyJet operates", as mentioned on page 42 of its 2019 annual report.