Are You Profiting from Your Core Operations?

The Coca-Cola Company, a beverage company, reported an operating profit of $11,150 million and a net income of $9,804 million for the year ended on December 31, 2021, while PepsiCo, Inc., one of the closest competitors of Coca-Cola, reported an operating income of $11,712 million and a net income of $7,679 million for the same reporting period. Comparing dollar values may not make much sense.

Let’s take a look at the margins. Coca-Cola reported an operating profit margin (OPM) of 28.84% and a net income margin (NPM) of 25.36% for the same reporting period. In comparison, PepsiCo reported an OPM of 14.74% and an NPM of 9.66%. Coca-Cola outperformed PepsiCo both in terms of OPM and NPM. By now, if you already feel overwhelmed by these numbers and accounting jargon, no worries, I will decode them for you. 

Income Statement for the year ended on December 31, 2021.
Particulars Coca-Cola
($ in Millions)
PepsiCo
($ in Millions)
A. Revenue from operations 38,655.00 79,474.00
B. Cost of goods sold 15,357.00 37,045.00
C. Gross Profit (A -B) 23,298.00 42,429.00
D. Operating expenses 12,148.00 30,717.00
E. Operating profit (C - D) 11,150.00 11,712.00
F. Non-operating incomes 3,831.00 151
G. Non-operating expenses 5,177.00 4,184.00
H. Net profit (E + F - G) 9,804.00 7,679.00
I. Operating profit margin (E/A) 28.84% 14.74%
J. Net profit margin (H/A) 25.36% 9.66%

In simple words, operating profit is the profit a company makes from its primary revenue-generating activities or core operations.

For a manufacturing company, operating profit represents revenue from selling the products it manufactures (i.e., revenue from operations) minus the cost of goods sold and operating expenses (such as selling and administrative expenses) related to its primary activities.

You may also think of operating profit as gross profit minus operating expenses, where gross profit equals sales revenue minus the cost of goods sold. For a service company, operating profit would represent service revenue minus operating expenses. Note that the concept of cost of goods sold does not apply to a service company. OPM is operating profit divided by revenue from operations and is often expressed as a percentage.

Net profit is simply operating profit plus non-operating incomes minus non-operating expenses. Net profit margin is net profit divided by revenue from operations and is often expressed as a percentage. 

Key Formulas:

Gross Profit = Revenue from operations – Cost of Goods Sold

Operating Profit = Revenue from Operations – Cost of Goods Sold – Operating Expenses

Alternatively,

Operating Profit = Gross Profit – Operating Expenses

Operating Profit Margin (OPM) = Operating Profit/Revenue from Operations

Net Profit = Operating Profit + Non-Operating Incomes – Non-Operating Expenses

Net Profit Margin (NPM) = Net Profit/Revenue from Operations

 

While OPM, as the name suggests refers to the profits earned from the core operations of the company, the NPM reflects the actual margin earned after considering the effect of non-operating costs, such as interest payments on debt and taxes, and non-operating incomes, such as income from investments, gains from the sale of non-current assets, etc. Now that you have understood what is meant by OPM and NPM and how to calculate them, a logical question that might arise at this juncture is which one is a better measure of profitability?

The answer depends on the context rather than the content. There are occasions when the OPM is a more useful measure (e.g., when we want to measure the profitability of the core or primary business), and there are occasions when the NPM is preferred (e.g., when we want to measure the overall or actual profitability). As the OPM does not get impacted by non-operating and extraordinary items, it is often considered more reliable for assessing the profitability of the core business.

If we talk of beverage companies, such as Coca-Cola and PepsiCo, the OPM would just include the profits generated from the beverage business. The revenues generated by the beverage business and the related costs of the beverage business alone will be considered. Incomes like interest on investments will be excluded. In this context, when we talk of operating costs, we refer to expenses directly attributable to the core beverage business.

Thus, we will include the cost of raw materials used, the cost of converting the raw material into beverages, the related labour costs, the salaries to manage the administration and sales teams, depreciation on assets, etc. The difference between the operating revenues and the operating costs represents the operating profit.

Besides measuring the efficiency of the core operation, the OPM captures the financial viability of the core operation. When we evaluate the operating margins, it is the trend that is more important than the absolute numbers. For example, if the 5-year trend line is upward sloping, it is a good sign, while a dipping trend line is a sign of the core operations being under pressure. Margins should not be analysed standalone but rather have to be looked at compared to industry peers. For example, certain sectors like steel and telecom tend to have lower OPMs, while IT and Pharma enjoy much higher margins. Hence, OPM comparison across sectors may not make much sense. If the OPM is consistently above the sectoral average and is showing an upward trend, then it can be interpreted as a positive sign.

OPM does not factor in the leverage aspect and the tax burden, but NPM does. If the NPM is substantially lower than the OPM, the culprit may be the high leverage of the company, which might eat away most of the operating profits in the form of interest expenses. This could signal the company management for revisiting its borrowing policy and borrowing costs.

To sum up, OPM is the key to understanding how profitable the core operations of the company are. Is the company performing better than its peers in terms of OPM, and is the OPM showing an upward trend? If the answer is “Yes”, it is a positive sign. The NPM is the actual profit margin that the company earns, which the market is interested in. The NPM is what stock markets primarily factor in for valuations because the P/E ratio is calculated based on the net profits. Growth in net profits and rising NPM can be attractive for the stock's valuation. Both OPM and NPM have roles to play in evaluating a company’s profitability. A combination of both might be a better way of looking at profitability.

Topics: ACCA, CIMA, CPD, FRM