CHAPTER 11: PROFIT MARGINS – PROFITABILITY OF THE BUSINESS

CHAPTER 10: CASH FLOW – THE LIFE LINE OF BUSINESS

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The Effect of Associate & Joint Venture Accounting
The Leverage of Low Margin
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The Effect of Associate & Joint Venture Accounting

 

Let us go back to the Batu Kawan example. Table 5 shows selected financial data taken from Batu Kawan’s 2013 and 2014 annual report.

 

 

Table 5: Extracted Financial Data from Batu Kawan’s Statement of Comprehensive Income for Financial Year 2013 (in RM ‘000)
	KLK as Associate	KLK as Subsidiary
Revenue	362,025	9,466,245
Gross Profit	93,859	2,047,721
Operating profit	94,152	1,361,389
Share of profits of equity accounted investees, net of tax	427,594	13,668
Profit before taxation	513,383	1,285,791
Profit attributable to equity holders of the Company	483,709	483,709

 

 

Table 6 shows the resulting margins derived from Table 5.

 

 

Table 6: Profit Margins for Batu Kawan (in %)
	KLK as Associate	KLK as Subsidiary
Gross profit	25.93	21.63
Operating profit	26.01	14.38
Pretax profit	141.81	13.58
Net profit	133.61	5.11

 

 

The conclusion is that associate and joint venture accounting can have a significant impact on the pre-tax and net profit margins, as the accounting treatment adds to the profit base (the numerator of profit margin formula) but not the sales (the denominator). Gross profit and operating profit margins are not affected by either inclusion or exclusion of associate profits as recognition of associate profits comes after the calculation of operating profit.

 

 

The Leverage of Low Margin

 

Businesses with low margin are able to show a strong increase in profit when the margin improves. Let’s take the example of Thong Guan Industries Bhd (“TGI”). Table 7 shows the TGI’s financials extracted from TGI’s 2016 annual report and corresponding margin and growth calculated from the data.

 

 

Table 7: TGI’s Financials, Growth and Ratio
(in RM million)	2012	2013	2014	2015	2016
Revenue	631.2	720.3	740.2	711.0	742.9
Net profit	27.2	28.2	17.5	38.5	55.9
Net profit margin	4.31%	3.91%	2.36%	5.42%	7.52%
Revenue growth (yoy)	–	14.11%	2.77%	-3.95%	4.48%
Net profit growth (yoy)	–	3.54%	-37.96%	120.27%	45.04%

Note: yoy represents year-on-year

 

 

From the financial year 2014 to 2015, although the group’s revenue declined 3.95%, the increase in profit margin from 2.36% in 2014 to 5.42% in 2015 (which more than doubled) resulted in TGI’s profit surging 120.27%. Similarly, from 2015 to 2016, although TGI only reported a revenue growth of 4.48%, profits increased by 45.04%, thanks to a 39% increase in net profit margin, from 5.42% in 2015 to 7.52% in 2016.

 

Likewise, the opposite is also true. From 2013 to 2014, although revenue grew 2.77%, a 1.55 percentage point decrease in margin (from 3.91% to 2.36%) resulted in a 37.96% drop in profit.

 

Note:

There is a common confusion between “percent” and “percentage point”. Percentage point is the difference between percentages. In the above case, a fall in percent from 3.91% to 2.36% indicates a 1.55 percentage point decrease, and not a 1.55% decrease. 

 

This concludes Chapter 11. Next week, we will explore Chapter 12: Operating Ratios.

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