Profitability ratios help in the analysis of the combined impact of liquidity ra

Question

Profitability ratios help in the analysis of the combined impact of liquidity ratios, asset management ratios, and debt management ratios on the operating performance of a firm Your boss has asked you to calculate the profitability ratios of Sixty-Second Avenue Inc. and make comments on its second-year performance as compared to its first-year performance. The following shows Sixty-Second Avenue Inc.'s income statement for the last two years. The company had assets of $8,225 million in the first year and $13,157 million in the second year. Common equity was equal to $4,375 million in the first year, and the company distributed 100% of its earnings out as dividends during the first and the second years. In addition, the firm did not issue new stock during either year. Sixty-Second Avenue InC. Income Statement For the Year Ending on December 31 (Millions of dollars) Year 2 4,445 1,610 Year 1 3,500 1,495 140 1,635 1,865 196 1,669 668 1,001 Net Sales Operating costs except depreciation and amortization Depreciation and amortization Total Operating Costs Operating Income (or EBIT) Less: Interest Earnings before taxes (EBT) Less: Taxes (40%) Net Income 1,832 2,613 353 2,260 904 1,356

Explanation / Answer

This question requires application of financial ratio analysis.

1) Operating Margin = Operating Income/Net Sales

For Year 2, Operating Margin = 2,613/4,445 = 58.79%

2) Net profit margin = Net Income/Net Sales

For Year 1, Net profit margin = 1,001/3,500 = 28.6%

3) Return on Total Assets = Net Income/Total Assets

For Year 2, Return on Total Assets = 1,356/13,157 = 10.31%

4) Return on Equity = Net Income/Total Equity

Now, as mentioned in question, 100% of earnings in year 1 are distributed as dividends. This means the amount of equity in year 1 and year 2 would remain the same.

For Year 2, Return on Equity = 1,356/4,375 = 30.99%

5) Basic Earnings Power = EBIT/Total Assets

For Year 1, BEP = 1865/8225 = 22.67%

Multiple Choice Question

Tue statements are Statement 1, 3.

Statement 1: This statement is valid. Operating income = Revenue - Cost of Goods Sold - Operating Costs. Operating Margin = Operating income/Net sales. Based on these two equation, we know that operating margin wouyld improve if revenue increases (due to higher price or volume) or operating cost decreases.

Statement 2: This statement is false. Net profit margin = Net Income/Sales. This will increase when net income increases (assuming sales constant) or sales decreases (keeping net income constant). Simple increase in net income may not reveal the direction of net profit margin.

Statement 3: This statement is true. Net profit = Operating Profit - Interest - Taxes. When net profit margin decreases, even though the operating margin increased, it is driven by interest and taxes paid by company.

Statement 4: This statement is false. If new equity is issued but net income remains constant, ROE will decrease. This is evident from the formula for ROE, which says ROE = Net Income/Equity.

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