6. Profitability ratios A Aa Profitability ratios help in the analysis of the co

Question

6. Profitability ratios A Aa 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 Spandust Industries Inc. and make comments on its second-year performance as compared to its first-year performance The following shows Spandust Industries Inc.'s income statement for the last two years. The company had assets of $4,700 million in the first year and $7,518 million in the second year. Common equity was equal to $2,500 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. Spandust Industries Inc. Income Statement For the Year Ending on December 31 (Millions of dollars) Year 2 Year 1 2,540 2,000 1,365 1,268 80 1,492 1,348 1.048 652 85 943 567 227 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%) 127 105 377

Explanation / Answer

Calculation of Profitability ratios:

Year 1:

Profit Margin = Net Income ÷ Net Sales
Profit Margin = $340 ÷ $2,000
Profit Margin = 0.17 = 17%

Basic Earnings Power = EBIT ÷ Total Assets
Basic Earnings Power = $652 ÷ $4,700
Basic Earnings Power = 0.1387 = 13.87%

Year 2:

Operating Margin = EBIT ÷ Net Sales
Operating Margin = $1,048 ÷ $2,540
Operating Margin = 0.4126 = 41.26%

Return on Total Assets = Net Income ÷ Total Assets
Return on Total Assets = $566 ÷ $7,518
Return on Total Assets = 0.0753 = 7.53%

Return on Common Equity = Net Income ÷ Common Equity
Return on Common Equity = $566 ÷ $2,500
Return on Common Equity = 0.2264 = 22.64%

True Statement:

If a company's operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes.

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