6. Profitability ratios Profitability ratios help in the analysis of the combine

Question

6. Profitability ratios Profitability ratios help in the analysis of the combined impact of liquidity ratios, asset management ratios, and deblt management ratios on the operating performance of a firm Your boss has asked you to calculate the profitability ratios of Dernham Inc. and make comments on its second-year performance as compared to its first-year performance. The following shows Dernham Inc. 's income statement for the last two years. The company had assets of $9,400 million in the first year and $15,037 million in the second year. Common equity was equal to $5,000 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 Dernham Inc. Income Statement For the Year Ending on December 31 (Millions of dollars) Year 2 Year 1 5,080 4,000 1,723 160 2,109 1,883 2,971 2,117 169 2,674 1,948 779 1,604 1,169 Net Sales Operating costs except depreciation and amortization 1,855 254 Total Operating Costs Operating Income (or EBIT) Less: Interest Earnings before taxes (EBT) Less: Taxes (40%) Net Income 297 1,070 Calculate the profitability ratios of Dernham Inc. in the following table. Convert all calculations to a percentage rounded to two decimal places. Ratio Value Year 2 Year 1 52.93% Operating profit margin Net profit margin Return on total assets Return on common equity Basic earning power 31.58% 12.44% 23.38% 19.76% Decision makers and analysts look deeply into profitability ratios to identify trends in a company's profitability Profitability ratios give insights into both the survivability of a company and the benefits that shareholders receive Identify which of the following statements are true about profitability ratios. Check all that apply A higher operating profit margin than the industry average indicates either lower operating costs, higher product pricing, or both An increase in a company's earnings means that the net profit margin is increasing If a company's operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes. 0 If a company issues new common shares but its net income does not increase, return on common equity will increase.

Explanation / Answer

Answer 1) YEAR 2 YEAR 1 a Net sales        5,080        4,000 b Operating cost except depreciation and amortization        1,855        1,723 c Depreciation and amortization            254            160 d Total operating cost        2,109        1,883 e Operating income (or EBIT)        2,971        2,117 f Less : Interest            297            169 g Earning before tax (EBT)        2,674        1,948 h Less: Taxes        1,070            779 i Net income        1,604        1,169 j Asset 15037 9400 k Common equity 5000 5000 l=e/a Operating profit margin 58.48% 52.93% m=i/a Net profit margin 31.58% 29.22% n=i/j return on total asset 10.67% 12.43% o=i/k return on common equity 32.09% 23.38% p=e/a Basic earning power 19.76% 22.52% Answer 2) Below statement are true higher operating profit margin than the industry average indicate either lower operating cost, higher product pricing, or both An increase in a company's earning means that the net profit margin is increasing 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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