CHAPTER 11: PROFIT MARGINS – PROFITABILITY OF THE BUSINESS

CHAPTER 10: CASH FLOW – THE LIFE LINE OF BUSINESS

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After having a basic understanding of the financial statements, we will look into converting the reported financial numbers into ratios.

We will not go into all the financial ratios but will highlight some of the key ratios that are useful for analysis purposes. Ratios can be categorised into three broad categories, being [1]. Profitability ratios, i.e. Profit Margins [2]. Operating ratios, and [3]. Financing ratios.

Before we proceed further, I would like to stress that ratios cannot be used in isolation. Ratios must be used either as a comparison with historical trends (i.e. as trend analysis), and/or with peers.

In addition, when interpreting ratios, the analyst must have an understanding of the nature of the business and the business structure of the companies. Forming a conclusion based solely on ratios without understanding the nature of the business is a risky affair.

Profit margin ratios measure how profitable a company is. Margin ratios are derived by dividing profits with revenue.

Profit Margin =	Profit
	Sales

 Table 1 below shows the revenue and profit numbers extracted from the annual reports of two listed pharmaceutical companies in Malaysia, namely Apex Healthcare Bhd (“Apex”) and Pharmaniaga Bhd (“Pharmaniaga”). Both companies are involved in manufacturing and trading of pharmaceutical products.

Table 1: Financial Year Ending 31 December (in RM million)
Apex	2012	2013	2014	2015	2016
Revenue	398.6	418.5	499.2	526.9	581.3
Gross Profit	101.1	105.6	116.1	119.7	128.3
Operating Profit	42.5	41.4	44.7	47.7	46.5
Pretax Profit	42.3	40.6	45.6	45.8	46.3
Net Profit*	29.0	30.0	33.9	34.2	35.0
Pharmaniaga
Revenue	1,812.3	1,946.6	2,122.9	2,189.3	2,189.0
Gross Profit	293.2	297.6	349.5	352.9	343.2
Operating Profit	117.7	106.4	141.1	126.8	104.7
Pretax Profit	103.3	93.0	125.6	112.7	72.0
Net Profit*	61.7	55.2	93.8	84.0	45.6

Note: * refers to net profit attributable to shareholders. We will be using this representation throughout the case study for Apex and Pharmaniaga.

The resulting profit margins are as per Table 2.

Table 2: Margins (in %)
Apex	2012	2013	2014	2015	2016
Gross Profit	25.37	25.23	23.26	22.73	22.08
Operating Profit	10.65	9.90	8.96	9.05	8.00
Pretax Profit	10.62	9.71	9.14	8.70	7.96
Net Profit	7.28%	7.17%	6.78%	6.50%	6.01%
Pharmaniaga
Gross Profit	16.18	15.29	16.46	16.12	15.68
Operating Profit	6.49	5.47	6.64	5.79	4.78
Pretax Profit	5.70	4.78	5.92	5.15	3.29
Net Profit	3.40%	2.84%	4.42%	3.84%	2.08%

 

One of the first uses of ratio is trend analysis. From Table 2, one can note that the margins for both companies are on a declining trend. This warrants further study and analysis of the industry on whether or not it is due to industry trend or certain challenges faced by the companies involved.

On peer comparison basis, Apex’s profit ratios are better than Pharmaniaga’s at all levels, i.e. gross margin, operating margin, and even pre-tax margin. However, the business exposure has to be taken into consideration.

 Table 3 shows the segmental performance of both companies.

Table 3: Segmental Results Based on 2016 Annual Reports (in RM million)
Apex
Revenue*	Manufacturing & marketing	111.7
	Wholesale & distribution	547.9
	Corporate	44.1
Pretax profit#	Manufacturing & marketing	31.7
	Wholesale & distribution	19.1
	Corporate	-2.3
Pharmaniaga
Revenue*	Logistic & Distribution	2,162.3
	Manufacturing	419.9
Pretax profit / (loss)#	Logistic & Distribution	(14.3)
	Manufacturing	96.6
*Including inter-segment sales #Before inter-segment adjustments and eliminations

Inter-segment sales are sales between divisions. For instance, both companies manufacture pharmaceutical products, and are also involved in the trading and distribution of pharmaceutical products. Thus, manufacturing and trading are regarded as separate revenue centres. The sales from the manufacturing division to the trading division are regarded as inter-segment sales.  

We are using numbers that include inter-segment sales in Table 3 so as to show apple-to-apple comparison, considering the method of recognition differs between both companies.

From table 3, note that the losses incurred by Pharmaniaga’s logistics & distribution division and comparatively lower manufacturing margin compared with Apex results in Pharmaniaga having a lower group margin.  

Next week, we will explore the relationship between profit margin and sales volume.

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