© 2000 John Petroff
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© 2000 John Petroff |
5)- Net profit margin
A company's profitability is very often evaluated by comparing earnings to sales rather than to investment. This is done in order to judge management's strategy with respect to administrative, general and overhead expenses. This analysis is a major complement to the analysis of gross profit margin discussed in Chapter 9. Here the net profit margin NPM is given by dividing net profit after tax PAT by sales
NPM = PAT / Sales
Although this is an important and useful statistic, the ratio is automatically calculated in a normalized income statement, and is not given as much recognition as ROA or ROE discussed in previous sections. But its major purpose is, as previously stated, to assess overhead costs. That can, however, be done more effectively by studying each individual cost as it relates to sales, as argued in the first section of this chapter, and as it is done a little later.
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For this example, we use Lucent Technologies once more. From Table T-6.7, Lucent Technology Income Statements, we take 1999 profit after tax of $ 4,766 millions and sales of $ 38,303 millions. This allows us to calculate the 1999 net profit margin of NPM = 4,766 / 38,303 = 0.1244 or 12% which is also found in Table T-5.9, Lucent Technologies Normalized Income Statement. However, Table T-5.9 shows that the year before, the net profit margin was only 3%, and even less in prior years. We remember, however, that Lucent Technologies has an extraordinary gain from the cumulative effect of accounting change in 1999, which inflated its profit after tax. Excluding the extraordinary item the profit after tax in 1999 was $ 3,458 millions and the adjusted net profit margin is NPM = 3458 / 38,303 = 0.0903 or 9% |
RMA stops its normalized income statement at profit before tax (for the reasons earlier indicated). Therefore, the before tax net profit margin has to be used when planning comparison with industry statistics:
NPMb = PBT / Sales
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We continue with Lucent Technologies. Instead of profit after tax, we now take 1999 profit before tax of $ 5,443 millions from Table T-6.7, Lucent Technology Income Statements. With sales of $38,303 we obtain the before tax net profit margin NPMb = 5,443 / 38,303 = 0.1421 or 14% This is the value found in Table T-5.9, Lucent Technologies Normalized Income Statement. And we note in Table T-5.9, that the net before tax profit margin was 8% in 1998, which is surprising in light of the previously noted very low net after tax profit margin of 3%. This suggests that the tax rate used in Lucent Technologies income statement in 1998 was much higher than the one used in 1999. Note #8 to financial statements discloses in a table reproduced in Table T-13.4 below, that indeed, Lucent Technologies used an effective tax rate of 58.8% in 1998 (and 69.2% in 1997), compared to only 36.5% in 1999. The note indicates "The following table presents the principal reasons for the difference between the effective tax rate and the United States federal statutory income tax rate."
This is an usual note. And the effective tax rates for 1998 and 1997 are most unusual. Although the company's calculation of effective tax rate is most certainly legitimate, nevertheless, as a consequence, there is a clear and significant distortion in profit after tax in these two years. This is the type of distortions that justifies RMA's omission of after tax statistics. Moreover, RMA is not alone in that: Moody's statistics in Table T-3.2 also do not include taxes. Having determined that the profit margin is more reliable before rather than after tax, we proceed to an evaluation of Lucent Technologies performance on the basis of its 1999 net before tax profit margin of 14%. The telephone communication industry results are dismal: the reported average is minus 32.6%. Even among the very large firms the before tax profit margin is only 7.3%. The telecommunication services industry is not doing much better with the large firms experiencing a before tax profit margin of minus 17.7%. This reflects the turmoil in the industry. Clearly Lucent Technology is outperforming its competition and stand to gain from the industry turmoil in the long run. |
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Net profit margin is affected by the inclusion of extraordinary items. To avoid this distortion, it is preferable to look at operating profit or earnings before interest and taxes (EBIT), which is also before extraordinary items. The most reliable statistic is therefore the net operating profit margin which is given by
NOPM = EBIT / Sales
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First, let us finish our evaluation of Lucent Technology. We take the 1999 operating income of $ 5,406 millions from Table T-6.7, Lucent Technology Income Statements, and match it against the sales of $ 38,303 millions. This gives us a net operating profit margin of NOPM = 5,406 / 38,303 = 0.1411 or 14% which is also found in Table T-5.9, Lucent Technologies Normalized Income Statement. We note that the net operating profit margin is practically equal to net before tax profit margin: this is because other income offsets the interest expense. And so is it also true for 1998 when net operating profit margin is equal to net before tax profit margin of 8%, as shown in Table T-5.9. We conduct the evaluation by comparing with the telephone communication and communication services industries, and conclude that Lucent Technologies is thriving in industries in turmoil with negative profit margins (-27.3% and -3.5%). Another approach is to compare Lucent Technologies net operating profit margin of 14% to Moody's rating ratios requirements. In the previous section, we determined that Lucent Technologies could aspire to a Moody's AAA rating on the basis of its outstanding return on equity. On the basis of net operating profit margin, however, Lucent Technologies could only salvage a A rating if the Median Key Financial Ratios of Industrial Companies by Moody's Rating Category 1987-1989 in Table T-3.2, were to apply. |
See review questions Q-13B5.1 and Q-13B5.2.
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