Concept of Core Earnings
The concept of core earnings is the actual earnings earned by the company’s core business. Many times, the earnings or profits reported in the income statement are affected by items not related to the core business of the company.
Note that we are not talking about misleading income statement, nor are we saying that the income statement is wrongly presented. The treatment adopted by companies in preparation of their income statement is in accordance with the accounting standards (unless of course the financial statements have been “qualified” by the auditor expressing that the financial statements are NOT true and fair).
What we are doing is simply trying to measure the core earnings of the company by stripping off the income and expenses which are not related to the business operations of the company.
Using TexCycle’s example, Table 4 shows our calculation of TexCycle’s core earnings. The line items are derived from Note 8 of TexCycle’s Notes to the Accounts presented in page 89 and 90.
|Table 4: Calculation of TexCycle’s Core Earnings (in RM)|
|Reported Net Profit||7,373,632||15,176,682|
|Allowance for doubtful debts||582,613||952,684|
|Bad debts written off||–||70,022|
|Changes in fair value of unit trust||(165,146)||30,415|
|Property, plant & equipment written off||23,080||61,489|
|Unrealized loss/(gain) on foreign exchange||(27,857)||289|
|Gain arising from fair value of investment property||–||(6,229,300)|
|Allowance for doubtful debts no longer required||(479,536)||(208,933)|
|Gain on investment in unit trusts||(128,172)||(175,958)|
|Interest income from short-term deposits||(25,181)||(48,889)|
|Gain arising from disposal of property, plant & equipment||(125,000)||(1,000)|
|Provision for litigation costs no longer required||(31,250)||–|
|Gain arising from insurance claim on loss of property, plant & equipment||(750)||(8,300)|
|Realized gain on foreign exchange||(13,605)||(345)|
|Legal compensation received||(40,062)||–|
How are the adjustments made? For instance, in the income statement, TexCycle recognised RM952,684 as expense in the financial year 2016 for allowance for doubtful debts. To adjust back this item, we “add” back the allowance for doubtful debts to derive 2016’s core earnings.
In short, to derive core earnings, non-core expenses that have been deducted as expenses in the income statement will be added back, and non-core earnings that have been recognised as income in the income statement will be deducted.
On core-earnings basis, TexCycle reported an increase in core earnings from RM6,942,766 in financial year 2015 to RM9,618,856 in financial year 2016.
One of the major items that resulted in the difference between the reported net profit and the core earnings in financial year 2016 is the gain arising from revaluation of property, which amounted to RM6,229,300.
Even after eliminating the non-core earnings items, one can still conclude that TexCycle’s growth coming from its core operations is still strong.
In some cases, the non-core items are well presented in the income statement itself. Take the case of Mieco Chipboard Bhd (“Mieco”). Table 5 is an extract from Mieco’s Statements of Profit or Loss from the company’s 2016 annual report.
|Table 5: Extract from Mieco’s 2016 Statement of Profit or Loss|
|(in RM ‘000)||2015||2016|
|Net profit for the financial year||18,643||82,678|
|Adjustments to derive core profit:|
|Impairment of property, plant & equipment (a)||7,809|
|Gain on disposal of subsidiary (b)||–||(35,000)|
|Write back of impairment of property, plant & equipment (c)||–||(28,134)|
|Tax credit (d)||–||(10,159)|
In next posting, we will take a look at how to determine which income and expense items to adjust in order to derive core earnings