In Example 2 of Reading 17 - Inventories (the one about CAT) the answers to question 8 throw this up:
You are asked to calculate the gross profit margin and net profit margin. CAT’s income statement breaks total sales and revenues into two line items:
- sales of machinery and engines
- revenue from financial products
So I go to calculate the gross profit margin and get it wrong because the answer says ‘revenue of financial products is excluded from the calculation of gross profit’.
What’s the rationale behind that? These aren’t nonoperating financial revenues (like MTM gains on a derivative), they are a major component of sales for CAT.
Then in the calculation they give for net profit margin, the sales figure they use is the sum of both line items.
One definition of sales in gross profit margin and another for net profit margin - how does that work?
Gross profit is the profit resulting from a company’s ordinary business activities. For example, Southwest generates revenues through selling airline tickets. The operating costs associated with generating those revenues would be deducted to arrive at gross profit. Southwest also engages in fuel futures, but they don’t do so in order to generate revenues as they are in the airline industry, not in the investment industry. Similarly, they may sell a retired jetliner for a price above book value and realize a gain from the transaction. That gain isn’t realized through ordinary business activities. They had an absolete fixed asset that they had to get rid of. Just as easily as selling it for a gain, they could have realized a loss. As such, gains and losses realized from engaging in such activities are considered nonoperating items, which are excluded from the gross profit calculation, but included in the net profit calculation.
The distinction is made because nonoperating gains and losses are not considered sustainable. Whereas gross profit is representative of the company’s core business and ability to continue as a going concern, net profit attempts to display all economic activity over the period.
Good answer, makes a lot of sense, and that may be the distiniction that CAT makes. But the examples you gave are different. Financial services are now a major part of CAT’s business, not some incidental nonoperating segment. The company has a subsidiary called Caterpillar Financial Services Corporation, whose raison d’etre is to profit from financial services. Yes it may have been created to support sales at their parent, but now they make recurrent, predictable profits that you can expect to persist indefinitely. Airlines don’t have financial services subsidiaries.
The financial services division of CAT appears to me to make consistent and sustainable profits.
I would agree that the revenues from CAT’s financial services subsidiary is a significant portion of continuing revenue; however, CAT is still in the manufacturing industry. The specific example you are talking about even makes a point to identify CAT is “the largest maker of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines in the world.” The example further makes the distinction between the two revenue streams. The question is calling on you to link the discription of the industry with the outline of the industry provided to the revenue streams presented on the P&L.
If CAT was a multinational conglomorate there would be a much stronger case to include revenue from financial products in the calculation of gross profit (as net interest), but the question clearly limits CATs industry discription to manufacturing. I personally think it is an extremely nuanced distinction, which has no place in this reading (at least not without a more detailed explanation by the author).
Note also, there is a distinction between operating profit and gross profit. The distinction is not whether this is operating income or not.