(FORTUNE Magazine) – LAST YEAR was a good one for corporate profits -- right? Well, that is the general perception, and taken as a whole it is still correct, but the most recent data from the Commerce Department show that profits slumped in the fourth quarter. The drop was widespread, despite strong growth in real GNP; it even hit the resurgent manufacturing industries, many of which were operating at robustly high levels of capacity. A measure of good news is hidden in this disappointment: Business was not able to take advantage of those operating rates to jack up prices. But now that profits will be growing from a lower base, the setback will shrink this year's gains to less than those we forecast a few months ago. If profits continue to sag, business will have to cut capital spending or borrow more. Either would weaken the economy. This seems a remote possibility, and FORTUNE still expects profits to get back on a solid rising trend. Profits can, of course, be measured in all sorts of ways. The most rousing numbers for last year were those reported to the shareholders by the biggest companies in the booming industrial sector: the FORTUNE 500. The 500 recorded an astonishing 41% increase last year, including some gains in earnings from abroad. At the other extreme was that rigorous number, operating profits, calculated by the Commerce Department using straight-line depreciation at replacement cost and excluding phantom inventory profits. For all nonfinancial companies, a much broader universe than the 500, operating profits declined 4%. Book profits, which companies report to the tax collectors using accelerated depreciation and including inventory profits, rose 9% (see chart). The fourth-quarter beating is not the result you would have expected, given the high operating rates at the average company. For business in general, capacity utilization -- measured by the ratio of output to capital stock -- is at the best level since 1981. Manufacturing utilization in the fourth quarter was 82.3% of capacity, up 2.5 percentage points in a year and the highest since early 1980, just before the recession that helped usher in the disinflationary period that we've been going through. To be sure, manufacturing capacity utilization is still more than five points below the highly inflationary peak in 1973. But utilization in textiles and chemicals is close to those awesome heights, and the paper industry is about as short of capacity now as it was then. So why did profits drop? The culprits were unit labor costs, which swelled at an annual rate of nearly 5% after showing very little rise in the previous four quarters. Since labor costs account for 65% of corporate GNP, the surge really squeezed profits. Business, which usually sets prices based on longer- run changes, evidently decided the cost bulge was temporary and chose not to offset it by raising prices in a competitive marketplace. That judgment looks correct. The bulge in labor costs resulted from a shortfall in productivity, not a surge in pay increases. In the first three quarters of 1987, nonfarm productivity rose at a respectable 2% annual rate; in the fourth quarter, it fell. Manufacturing productivity, which had climbed at a 4.5% rate most of the year, flattened out. There's no sure way to account for the fall, since a single quarter can reflect all sorts of aberrations. Possibly business hired a lot of new workers as output accelerated, a process that is always a short-run blow to efficiency. But productivity outside of manufacturing is apparently declining less in the first quarter, and manufacturing is rebounding to a 2.5% rate of rise. So productivity for business in general is holding about steady. As manufacturing picks up faster and the other industries at least hold even, productivity will likely return to a 1% or so annual improvement. A recovery in productivity from the fourth-quarter setback won't solve the profit problem, however, because it will bring only short-lived relief from mounting labor costs. Wage increases have been modest for several years. In the second half of 1987, for example, hourly compensation rose at a moderate 3.5% rate, up from a 2% pace in the first half but only about the same as in 1986. When adjusted for inflation, wages have been declining for the past year, and 1988 is a heavy bargaining year for unions eager to catch up. With unemployment expected to rise only a bit from its present 5.7%, non-union workers have a lot of bargaining power too. The speedup hasn't started yet, but by the middle of next year compensation will be increasing at about a 5% rate, and unit labor costs at close to 4%. COMPANIES MAY well have to eat these added costs. Capacity is not yet so strained that businesses can blithely pass them on, and utilization isn't likely to increase much in the next year or so. The only consolation is that as the labor cost increases become general and lasting, competition is not apt to be tough enough to force margins still lower. The most likely prospect is that companies will succeed in maintaining their cash-flow margins, which collectively are after-tax profits plus depreciation as a percent of corporate GNP. These are the margins corporations most often look at in making pricing decisions. Operating cash-flow margins reached a peak for this expansion of 17.7% in 1984, as the period of rapid growth ended, and then slipped to 15.9% by 1987. They will hold about there this year and in early 1989. Stable cash-flow margins will translate into a very slight pickup in profit margins, from 4.8% in 1987 to 5% in 1988 and early 1989. But profit margins will still be below par for this expansion, as well as lower than the 6.3% average of the 1970s and the 8.5% of the 1950s and 1960s. But if profits in the quarters ahead won't be what we thought they would a few months ago, the total dollars left in the till will at least be respectable. Taking into account the 6% increase in corporate GNP in 1988, operating profits after taxes for all nonfinancial companies will rise 10%, hitting a new record by next year. Book profits will rise about as fast as operating profits. Cash flow has become the apple of many an investor's eye, but it is even more important for the capital goods industries and credit markets. Industry's spending on plant and equipment, along with its borrowing requirements, depends on cash flow -- specifically, operating cash flow, which is stripped of inventory profits. After dipping in the fourth quarter along with profits, operating cash flow will increase 10% by the middle of 1989, a sizable improvement over the 3.5% gain of the past six quarters. But real gains will be less impressive. The prices of capital goods, which FORTUNE uses to deflate cash flow, will probably rise much faster in the year or so ahead than they have lately. We expect the gain in real cash flow to be held to 4% (see chart). So internal corporate funds will provide only a mild stimulus for continued real growth in capital spending this year and next. According to the Commerce Department's latest survey of capital spending plans, companies have scheduled an 8.8% increase in dollar outlays this year, a touch more than FORTUNE is forecasting. And Commerce expects more bang from these bucks than we do, since it estimates that prices of capital goods will go up just 0.8%. On FORTUNE's assumption of accelerated rises in prices, real spending will expand modestly. What about borrowing? Corporations will continue spending 80% of their cash flow on capital goods, just as they have over the past five years, and won't try to boost real capital spending by dipping into the credit well. Short-term financing of inventories has fluctuated with the swings in accumulation, rising in 1984 and again during the past several months. That should slacken now that business is working off the excesses. The biggest single demand for credit is coming from mammoth bond issues for leveraged buyouts and takeovers, which have retired $80 billion or so of stock in each of the past four years. U.S. companies have also been borrowing heavily over the past couple of years to boost liquidity. They have lifted liquid assets to 36% of short-term liabilities, up from 32.5% only two years ago and the highest level since the mid-1960s. Corporate treasurers evidently want plenty of liquidity as they face the mountain of outstanding debt and general uncertainty about the economy. Companies will probably continue to replace stock with bonds at something like the current rate. But borrowing to add liquid assets and finance inventory will likely slow in the next few quarters. So after bulging in the fourth quarter to a $240 billion annual rate, total business borrowing should gradually recede to near the $170 billion total for last year. Despite that fourth-quarter hit, profits will grow smartly enough to keep pressure off the credit markets -- and perhaps reassure nervous investors.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Heading for New Heights This Du Pont plant in New Jersey will cash in on strong demand for basic chemicals. Operating profits are the better economic measure; book profits are those reported to the IRS. DESCRIPTION: Operating profits and book profits, after taxes, 1985-1987, with forecasts for 1988 and first half of 1989.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: More Purchasing Power Cash flow for nonfinancial corporations should break out of its doldrums and grow a bit faster than the prices of the capital goods it buys. DESCRIPTION: Operating cash flow, 1985-1987 with forecasts for 1988 and first half of 1989.