Analytical Review 101 – Part III

Profit Before Tax and Net Profit, Margins

How is Profit Before Tax arrived at?
If you look at Nestlé’s Income Statement; Profit Before Tax is arrived by using the Gross Profit less the following major items:

(a) Distribution and selling expenses
These expenses are mainly transportation costs incurred in delivering its’ products to its’ distributors & direct customers such as hypermarkets and dealers. Other selling costs consists of salespersons’ salaries, commissions, entertainment and other expenses. Advertising campaigns and product promotions expenses are also classified here.

(b) Administrative expenses
Costs incurred by back office departments such as Finance, Procurement, Credit Collection and Information Technology are usually lumped under these categories. Other fixed overheads (excluding factory overheads) will also be categorized here.

(c) Interest income
Interest income usually consists of interest earned on excess cash placed by the company in fixed deposits, short term money market deposits and other interest earning instruments.

(d) Interest costs
Interest costs consists of financing costs due to loans and borrowings secured by the company to finance its’ operations and capital expenditures.

How is the Tax Expense arrived at?
Tax expense consists of income tax liability payable by the company on its’ profits and deferred taxes. The income tax liability is largely out of the Company’s control, so it is of lesser importance in our analytical review.

How is the Profit After Tax arrived at?
Profit After Tax = Profit Before Tax – Tax Expense

Analytical Review
The Profit Before Tax (PBT) margin gives us an indication of the profit made by the Company from its' sales less ALL costs incurred including COGS and indirect costs such as selling, marketing, administration, financing and other costs.

An overview of the PBT margin of Nestlé from 2003 to 2007 indicates that its' margin has been hovering around 10% to 11% for the past four years. Overall, this figure is reasonably good as it means the company is making a profit of approximately RM0.11 for every Ringgit of sales made.

The Profit After Tax (PAT) margin signals the profit made after deducting the income tax payable to the Malaysian government. Review of the PAT margin for the past five years suggests that PAT margin is improving. However, this is largely due to tax incentives obtained as indicated in note 18 of the annual audited financial statements.

Conclusion:
A profit after tax of approximately 8% per annum is reasonable. However, it is not that impressive considering RISK FREE interest income from fixed deposits are approximately 3.70% whereas returns from EPF are about 5%. Please remember that Profit After Tax DOES NOT EQUAL TO Cash Earned as there is a timing difference in turning profits into cash (as indicated by the Quality of Earnings Ratio).

Further, there is always a moderate risk involved in investing in companies, even in one as established as Nestlé. As indicated earlier, comparison with Nestlé’s competitors’ PBT and PAT margins may give us a more complete picture as to the Nestlé's strength and weaknesses vis-à-vis the industry.