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2005: 70 percent 2006: 72 percent 2007: 64 percent
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The company has excellent gross margins in excess of 60 percent for all three years However, one sees an 8 percentage point decline in gross margins in 2007, indicating that something has changed What are some of the possible reasons for a decline in gross margins
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There may have been a change in the product mix being sold A higher percentage of lower-margin items may have been sold The cost of supplies may have gone up The company may have changed its accounting system from a cash system to accrual This change in accounting system results in no change in the timing of cash receipts; since this is a cash business and therefore the company does not have receivables, the change in the system will not affect the timing of when revenues are recognized However, the accounting system change forces the company to recognize costs earlier The result of this change is potentially lower gross margins because costs are being recognized earlier, and therefore lower net profit as well The company may be buying from different suppliers at higher costs and/or selling to different customers
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An examination of the income statement shows that 2006 was the first year in which products were returned Also, and more importantly, as the note at the bottom of the statement shows, there was a change in the accounting method, from cash to accrual And as we just stated, the change does not affect revenues because this is a cash business, but it does have a negative effect on all three margins because more expenses are being recognized Therefore, as a result of the change, we are not comparing apples to apples with the prior year
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NET MARGINS What are acceptable net margins We ve determined that the Clark Company has outstanding gross margins But how do its net margins compare In general, net margins of 5 percent or better are considered very good According to Hussman Funds, since 1955, the average profit margins of the 500 largest US companies have ranged between 55 percent and 75 percent In fact, 2006 was a banner year for large US corporations, as the Fortune 500 largest US companies generated a posttax profit margin of 79 percent, equivalent to $785 billion This was a 29 percent increase over 2005 and obliterated the previous cyclical peak of $444 billion The top three companies in terms of net income, throughout the world, were US-based The net margins of these companies are shown in Table 5-10
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T A B L E 5-10
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Net Margin Top Ten
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Company Ambac Financial Group Prologis Public Storage MGIC Investment Linear Technology Gilead Sciences QUALCOMM Yahoo! Burlington Resources Apache
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Source: BusinessWeek, April 2006
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Net Margin, % 453 427 412 411 403 401 374 361 357 352
Privately owned companies want to minimize taxes, and therefore they reduce operating income, which in turn reduces their net income The point being made is that the net income is usually a manipulated number that understates the company s true financial performance A few exceptions might be companies that are preparing to go public or be sold These companies may want to look as financially strong as possible
Financial Statement Analysis
In contrast, a publicly owned company aggressively seeks positive net margins, as high as possible, because the net margin affects the stock price As one money manager remarked, There is a greater tendency among companies to pull out the stops to generate the kind of positive earnings that Wall Street demands 39 For example, a few years ago, America Online decided not to recognize some huge marketing expenses in its quest for positive annual earnings The Securities and Exchange Commission unearthed this fact and forced AOL to take a charge of more than $385 million in 1996, wiping out all the profit the company had made up to that point The greatest example of this kind of chicanery was the case of Enron, the one-time darling of Wall Street Through off-balancesheet transactions, Enron masked hundreds of millions of dollars of losses in its effort to continually beat analysts estimates The house of cards eventually crumbled, and one year after ranking number seven on the Fortune 500, Enron filed for bankruptcy The carnage was severe, with more than 5,600 employees losing their jobs and in many cases their life savings Over 20,000 creditors were left holding $63 billion in debt, and tens of billions in shareholder value was lost40,41 Government regulation has targeted this kind of fraudulent behavior, and it has had an impact A 2002 survey indicated that 59 percent of CFOs disclosed more information in financial statements than they had previously done, and 57 percent said that they planned to disclose more information in the next 12 months42 Moreover, the Sarbanes-Oxley reform act has targeted this kind of abuse and changed the way in which corporate boardrooms and audit firms operate However, this problem will never completely go away Therefore, when analyzing the financial statements of a privately or publicly owned company, beware Things especially net income may be significantly different from what the statements show The problem with looking at just net income for a public or private company is that income does not pay the bills Cash flow pays the bills Net income is typically an understatement of the company s cash flow because it includes noncash expenses such as depreciation and amortization In addition, expenditures that have nothing to do with the operation of the company may also be included, thereby lowering the company s net income It is common for owners of private companies to run certain personal
expenditures through their income statement because they view it as one of the perks of ownership Therefore, one must realize that net income can be, and usually is, a manipulated number For example, the late Leona Helmsley, owner of several upscale hotels in New York while she was alive, made improvements to her personal home and charged them against her company, thereby reducing the taxes owed She was convicted of tax evasion as a result and served time in prison One of the smoking guns used to convict her was an employee who quoted her as saying, Only poor people pay taxes The reality that net income can be a manipulated number is best illustrated by a controversy regarding the 1995 movie Forrest Gump The movie has grossed over $600 million worldwide, making it one of the highest-grossing movies in history A fellow who agreed to take a percentage of the movie s net income as his compensation wrote the story Believe it or not, this movie never reported a positive net income, and thus the writer was due nothing The issue was in dispute for a number of years and was recently resolved, finally opening the door for the long-awaited sequel to the original blockbuster What s the entrepreneurial moral of the story As an investor, never agree to take a percentage of the net income because you cannot control the expenses, be they real or make-believe Conversely, if you are the entrepreneur, always try to compensate investors based on net income, never on revenues Basing compensation on revenues has gotten many entrepreneurs in financial trouble, because giving someone a percentage of revenues ( off the top ) ignores whether a company has a positive cash flow The final problem that must be highlighted, with regard to putting too much importance on net earnings, is that the net earnings figure does not tell you where the earnings came from Did they come from strong company operations or from financial instruments A fundamentally sound company derives most of its earnings from operations, specifically from product sales or services rendered, not from interest earned on invested capital The primary reliance upon interest earned would force the company to be in the money management business Yahoo!, which had always been touted as one of the few profitable Internet
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