Core operating margin?

CFA Level II
#1

A warning sign that ordinary expenses are now being classified as nonrecurring or nonoperating expenses is:?

please see Pg. 358 in FRA volume II

I can’t seem to understand why a falling core margin would be a warning sign?

If this ratio is falling that means more expenses are being recognized in either cogs od SG&A which are not in the “Non recurring item bucket”?

HELP :slight_smile:

#2

I have the same question.

Shouldn’t this ratio be “increasing”?

#3

When core operating margin is falling, it means the company is bleeding. Management has an incentive (even bigger incentive in case of public companies) to show profits. One way to manipulate earnings [from continuing operations] is to shift regular operating items to the non-operating section of the I/S.

So consider this:

2009 COM (Core Operating Margin) = 10%

2010 COM = 7%

2011 COM = 6%

2012 COM = 9%

If you look at the trend, margins were falling, and then abruptly rose in 2012 (of course this is a simple example, but I’m sure public companies tend to be more subtle). One thing management may have done in 2012 is classified/reclassified some core expenses and then shifted them to the non-operating section of the I/S.

So what the question is trying convey is, you had falling core operating margins (until 2011 above) followed by a spike (increase) in negative special items (2012 above, when COM actually would have improved).

Hope this helps.

#4

Thanks Aether! Your example explained it very well.

Just one little thing if you (or anyone who knows i) don’t mind explaining. What are the ‘negative special items’ refering to? The closest I can think of are the expenses in core operation, where they become too big, thus are reclassified to the non-operating section. But I don’t see this ‘negative specil items’ phrase expained in the text. /th

#5

Negative special items are the ones listed in the non-operating section of the I/S. Items classified as unusual OR infrequent, items under discontinued operations, or items classified as extraordinary (only under GAAP). Even though the L2 material doesn’t explicitly specify the category of special items that management is likely to abuse, I’d think most would utilize the unusual OR infrequent bucket.

#6

Thanks so much!

#7

Excellent!!! Thank you kindly!

#8

wow aether smiley

#9

Thanks for the explanation!

#10

#next_pages_container { width: 5px; hight: 5px; position: absolute; top: -100px; left: -100px; z-index: 2147483647 !important; } This was all cleared to me until I flicked back to the example 5 (core operating Margin Warning sign, p. 340 & 341). In the solutions of that example the Core Operating Margin is calculated in different ways:

  1. Core Operating Margin = (Sales - COGS - SG&A) / Sales

  2. Core Operating Margin = (Sales - COGS - SG&A - Depreciation - R&D ) / Sales

In both cases the directional is the same as they decrease steadily and suddenly rise while at the same time a large special item is recognized.

If you turned back to page 339. The Core Operating Margin is defined as (sales - COGS - SG&A) / Sales. This ratio represents the pretax return on a money unit of sales resulting from the company’s operating margin.

The analysis remain the same, if the Core Operating Margin decrease year after year and suddenly spike up while a special item spike down we should consider it as Warning sign that a COGS or SGA items has been reclassified under special items to boost operating earnings.

For the exam should we be expected to use both of formula?