by Michael Brett
Profit and loss refinements
We looked last week at a simplified property company profit and loss account. But, as with the balance sheet, there are some complications that can crop up in practice and we need to look at the more common ones. Many are counterparts of items that we have already examined in the context of the balance sheet.
The first item you may come across which was not featured in our sample profit and loss account is “income from associated companies” or “income from related companies”. Remember that an associated company is not a subsidiary but usually a company in which the head company has a shareholding of between 20% and 50% and over which it exerts some management influence.
In the consolidated profit and loss account of the head company it takes in its proportionate share of the profits of the associated company or “associate”. So if Payola Properties and two other companies set up Verruca Ventures to develop the Toytown Estate in London’s dockland, and if each took a one-third share in Verruca, Payola would be entitled to one-third of Verruca’s profits, and this is the figure it would show in its consolidated profit and loss account. So if Verruca made £90,000 pre-tax, Payola would include £30,000 for its share, and would show it as part of its income before tax.
But note that £30,000 (or its equivalent after tax) is not necessarily the cash that Payola receives from Verucca. Verucca may have needed to hang on to its profits to finance further development and may therefore have declared a dividend much smaller than its profits, or may have paid no dividend at all. Watch this point when a company derives much of its profit from associates.
Next, minority interests. Payola, remember, owns only 70% of its Semolina Estates subsidiary and the founding Semolina family hang on to the remaining 30%. They are, therefore, entitled to 30% of Semolina’s profits. So in its consolidated profit and loss account Payola includes the whole of the profit of Semolina Estates. But before it can arrive at the earnings that belong to Payola shareholders it has to knock off 30% of the profits that Semolina contributed. It does this by making a deduction from its net profit after tax, equivalent to 30% of Semolina’s after-tax profits.
A similar deduction has to be made if Payola Properties itself has preference share capital in issue. Suppose it has £500,000 of 8% (net) preference shares. The dividend on these will be paid out of profits that have borne corporation tax and will amount to £40,000. So this amount also has to be knocked off Payola’s profits after tax before arriving at the amount of profit that belongs to Payola’s ordinary shareholders (remember the principle — the ordinary shareholders have a right to whatever remains after the company has met all its other obligations). So “equity earnings” or “earnings attributable to ordinary shareholders” will be calculated on the figure that remains after tax and any minority interests or preference dividends have been deducted.
A further complication: you will sometimes see in a company’s profit and loss account a figure for “exceptional items” or “extraordinary items”. This are items that do not arise in the course of the company’s normal trade. Suppose Payola happens to sell off a subsidiary company in the course of the year at a profit of £200,000. Selling companies is not part of Payola’s normal business, and it is an item that is unlikely to crop up every year. It therefore needs to be shown separately from Payola’s income from its normal business.
The rule is that exceptional items are added to (or knocked off) profits before tax — “above the line” in the jargon. Extraordinary items are accounted for at the net level after tax — “below the line”. The difference between the two is not always clear-cut — extraordinary items are meant to be the very unusual items that are furthest removed from the company’s normal business and least likely to crop up frequently.
But the important point for the analyst of company accounts is that he is trying to form a view of what the company is capable of earning on an ongoing basis. So if the company has added a large exceptional item before arriving at its pre-tax profits, the analyst will normally strip it out (and adjust the tax charge accordingly) before arriving at the figure on which he calculates earnings. Likewise, an exceptional deduction from profits will be added back in. Some companies are not above using exceptional items to try to present an inflated view of their performance.
Finally, there is the question of convertible stocks and their effect on future earnings. We saw earlier how an analyst could adjust asset values to take account of a convertible and come up with a figure for fully diluted assets per share. A comparable operation can be undertaken for earnings.
Payola currently produces £300,000 of pre-tax profit and net profits of £195,000 after all deductions except dividends. It has 3m £1 ordinary shares in issue, and pays a dividend of £130,000 net. Its earnings per share are 6.5p and the net dividend per share is 4.33p.
Suppose it has in issue £2m of 5% convertible loan stock, on which the annual interest charge is therefore £100,000, which is deducted before arriving at pre-tax profits. And suppose (since we need an extreme case to illustrate the principle) that Payola’s current share price is 240p but that the convertible stock was issued a considerable time ago when the shares stood at only 80p. The conversion terms are that each £1 nominal of convertible loan stock converts into one ordinary share of £1 — in other words, the conversion price is 100p and well below current levels. Thus, when the stock is converted it will create 2m additional ordinary shares of £1.
What happens on conversion is this. The loan stock disappears as a liability of the company and therefore the company saves the £100,000 of annual interest it was paying. Its pre-tax profits therefore rise from £300,000 to £400,000 and net profits rise from £195,000 to £260,000 after 35% corporation tax.
But 2m new shares have been created and therefore the company’s earnings have to be spread over 5m shares rather than the previous 3m shares. Earnings per share thus work out at 5.2p in place of the previous 6.5p, representing very significant dilution of the company’s earnings.
Even though the convertible stock may not yet be due for conversion, an investment analyst will tend to undertake this calculation — working out what the position would be if the stock were converted — to arrive at the “fully diluted earnings per share” figure. Since the dividend which a company pays or can pay normally depends on the profit it is capable of earning, a big prospective dilution of earnings per share is not good news for shareholders. It means that there is a considerable constraint on dividend growth. Even at the present dividend level of 4.33p net, the dividend on the new 5m shares would cost £216,500 as against £130,000 on the old 3m shares and if the company maintains its dividend at this level, dividend cover will reduce, at least temporarily. Convertibles are not always good value for companies with rapid earnings growth.
