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Getting Over The Finish Line - Inflating Profits To Meet Targets

Summary

Company inflated its operating profits by netting off non-operating incomes from its operating costs.

The Company did this to meet its profitability target as management compensation/bonus was dependent on achieving the target.

Often is the case that managements set profitability targets or provide guidance on the future profitability to the analyst community. However, not meeting these targets can have an adverse impact on the company’s stock and also on the management compensation. Therefore management might sometimes go out of their way to meet these targets.

For example, companies can inflate their operating profits by netting off non-operating incomes from operating costs.

We found this to be the case for a large global OEM which classifies other income as a deduction from operating expenses despite the other income not being a part of the operating activities of the business. This artificially inflates the operating margins.

In the below given table, we have looked at the adjusted EBIT margin (excluding the benefit of other income) and compared it with reported EBIT margin and target margin.

2007 2008 2009 2010 2011
Other Income (netted off from operating costs) 31 64 25 48 37
%Sales 0.80% 1.40% 0.50% 1.00% 0.70%
%EBIT 7.00% 13.00% 4.30% 7.40% 5.40%
Target EBIT Margin 12.00% 12.00% 14.00% 14.00% 16.00%
Reported EBIT Margin 11.70% 12.10% 12.70% 14.00% 13.90%
Actual EBIT Margin 10.90% 10.70% 12.10% 13.00% 13.20%

After excluding the "other" income, claims of reported EBIT margin improvement and target margin achievement appear overstated.

Management compensation/bonus was dependent on achieving the above mentioned target margins and netting off other income from costs helped them to achieve their targets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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