Probably a silly question but my head just can’t wrap around the following question from Schweser note:
A company accounts for its investment in a subsidiary using the equity method. The reported net profit margin is 14%. An analyst adjusts the financials and determines that the company’s own net profit margin is 8% while the subsidiary’s profit margin is 10%. The netprofit margin based on consolidation would most likely be:
A. less than 8%.
B. more than 14%.
C. between 8% and 14%.
The Answer is C because The equity method typically yields a higher measure of net profit margin.Consolidation is most likely to result in a net profit margin somewhere between the profit margins of the two entities.
I’m not sure if I misinterpreted the question but I assume ‘Consolidation’ refers to Acqusition method right? And under all these methods, the Net Income remains the same. However, the revenue is the smallest under the Equity method rwhich means Net Profit Margin (NI/Revenue) should be the greatest (in this case, it’s 8%).
So based on consolidation method this would only increase the Revenue and thus make the NPM smaller (less than 8%). So why it’s not A?
Consolidation over here implies the consolidated financials which the Holding company would prepare. And under equity method, margins are always higher because Revenue is less. The consolidated NP Margin won’t exceed 14% since it’s a given cap
Hi,
under the Equity Method you consolidate the pro rata net income of the investment but not the revenue.
Since PM = NI / Revenue the nominator increases and the denominator stays constant. As such, under the equity method margins will always increase.
Regards,
Oscar
I think your main weakness may be unrelated to understanding of the underlying concept, and more to do with simple comprehension (is English a second language?)
Question states: “A company accounts for its investment in a subsidiary using the equity method. The reported net profit margin is 14%.” Which I interpret as: Profit margin (equity method) = 14%.
You state “. However, the revenue is the smallest under the Equity method rwhich means Net Profit Margin (NI/Revenue) should be the greatest (in this case, it’s 8%).” Which I seem to interpret that you interpret profit margin is 8% under equity method.
It’s an old thread, but I started studying and I am stuck with this same question. English is not my native language, and I am struggling with the way the question and the response are formulated, and I need some help.
My reading is that we are given the net profit margin of two entities: 8% for the parent, and 10% for the subsidiary. We are also told that under the equity method the net profit margin is 14%. We are asked to choose the most likely net profit margin under the consolidation method, which I understand is the “acquisition” method.
I understand that any consolidation methods (proportional or acquisition) would have a lower net profit margin that the equity method.
What I do not understand is why the lower boundary would be 8%.
I can show easily that if the parent NPM is 8% and the subsidiary NPM is 10%, and the parent owns 50% of the subsidiary then I get a 14% with the equity method, a 8.75% with the proportional method, and 6.36% with the acquisition method.
I use P revenue: 200 - P Expenses: 184 - S Revenue: 240 - S Expense: 216
Ownership: 50%
The response is also confusing as it states “…somewhere between the profit margins of the two entities” The material never mentioned the concept of NPM between two entities, it does mention between two methods (equity vs consolidation).
Thank you, MikeyF, for your reply. The upper limit of 14% is given, so I do not have an issue with it, I am more concerned about the lower limit of 8% in the “right” answer C.
As you said:
Parent
Revenue: $100
Net Profit: $8
So: Expense: $100 - $8 = $92
Equity Method:
Revenue: $100
Expense: $92
Equity Income = $14 - $8 = $6
Net Profit: $100-$92 + $6 = 14 (I need $6 to get to $14)
NPM: 14/100 = 14% (given anyway)
As an aside, the Equity method is used when we own between 20% and 50%. Not less than 20%. So, I use 50%.
Acquisition Method:
Revenue: Revenue Parent + Revenue Sub
Expense: Expense Parent + Expense Sub
Minority Interest: (1-50%)* Sub Income
NPM = (Revenue - Expense - Minority) / Revenue
If in the Equity method, I needed $6 to get to $14, but $6 is only 50% of the subsidiary profit, then sub profit must be $12 ($6/50%).
If $12 is the Sub profit, and they told us the Sub NPM is 10%, then the Sub revenue must be $12/10% = $120, and Sub expense must be $120-$12 = $108.
Thank you, MikeyF, but I accounted for that line. It goes on saying that Parent NPM is 14% using the equity method. I got that under the Equity method the NPM is 14%.
OK ignore what the question is asking and just look at the numbers
P revenue: 200 - P Expenses: 184 -
P margin = 8%
S Revenue: 240 - S Expense: 216
P margin = 10%
Assume no up stream/down stream transactions and additional depreciation.
Consoldiated Aquisition Method
C Reveneue 440 P. Expenses 400
Net Income = 40 Net Margin = 9.09%
Net contolling interest (12)
Earnings attributable due to P s/holders = 28
We would calculate the net margin based on
Net Income = 40 Net Margin = 9.09%
Thank you, MikeyF, but net income is not 40, it is 28 (40 - 12). Because we report 100% of the subsidiary Revenues, don’t we need to subtract the minority interest of 12 (24*50%) to get to consolidated net income?
I agree with your calculations, but why not the 28 as net income? The net income is identical whichever the reporting methods we use.
We know from the question that under the equity method, the net profit margin (to the parent) is 14%: 14 over 100 or 28 over 200 in your example.
Therefore, the consolidated net income attributable to the parent under the acquisition method should also be 28, not 40; I would expect the net profit margin to be 28 over 440 (6.36%).
If ownership is 100% (which I doubt), the net income attributable to all shareholders (100%) under the equity method would be 16+24 = 40, or 40/200 or 20%, but not 14% as given in the question. Under the acquisition method, the net income attributable to all shareholders (100%) would also be 440-400 = 40, or 9.09%. But, as I mentioned the given input in the question is 14%, not 20%, so it can’t be 40.
This question does not look right. Maybe they meant to say, but without disclosure, that the ownership is at 100%, with a NPM at 14%. If it is the case, then answer C would make sense, because the net profit margin would be 8.75% and the result would be in between the net profit margin of the two entities. This statement is only and always) true if the ownership is 100%. But, I think that this is a very tortuous way to getting at answer C.
There they calcaulte net proifit margin (after adjusting for associates) from the Net Income before adjustments for non-controlling interests.
There are no accounting rules on defintions of ratios (apart from EPS).
But most analysts will use the net income before adjusting for non-controlling interests as otherwise, dur to the issues you have pointed out, it can be produce meaningless numbers.
Thank you, I looked at Nestle, and it’s not the same purpose. They are trying to isolate “Pure Nestle” net profit margin from its associates to run a Dupont decomposition. Therefore, they remove the income attributable to associates, and just keep Nestle income. That is equivalent to isolate the Parent’s income, go from 14% to 8% in the context of our original question.
In that Nestle case study when they calcualte net profit margin for dupont etc.
Do the use (for example 2014) See exhbit 2, 5 and 6
Profit fro the year 14,904 - attributable to all shareholders
OR
profit of which attributable to s/holders of parent 14,456 ?
They use the profit for the year number attributable to ALL shareholders. - 14,904 the number BEFORE adjusting for non-controlling interest
Exhibit 7 net proft margin = 14,904 / 91,612 = 16.27%
not 14,456/91,612 = 15.78%
When they make adjustments for the income from equity associates the starting point where do you see any deductions for non-controlling interest? They are adjusting for associates but not the non-controlling interests
The convention for net profit margin is to use
net income before non-controlliing interest adjustments - net income attributable to all shareholders.
Thank you, I am not thinking otherwise with the Equity Method. This Nestle example uses the equity method (see note 3), so we add a single line from Associates: 8,003 to arrive at 14,904 as Net Income, and get 16.27% as net profit margin, as we always did in our previous examples.
The non-controlling number does not apply with the Equity method. non-controlling interests do apply with the Acquisition method, which is not used here. The original question was about net profit margin using the Acquisition method.
I didn’t look closer, but I don’t think we can calculate net profit margin using the Acquisition method using this example because we do not have all the data from L’Oréal in this example. But I expect the same Net Income over a different revenue numerator (Nestle+L’Oréal).