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 firnm Your boss has asked you to calculate the profitability ratios of Stay Swift Corp. and make comments on its second-year performance as compared to its first-year performance The following shows Stay Swift Corp.'s income statement for the last two years. The company had assets of $3,525 million in the first year and $5,639 million in the second year. Common equity was equal to $1,875 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 Stay Swift Corp Income Statement For the Year Ending on December 31 (Millions of dollars) Year 2 Yar 1 Net Sales 1,905 1,365 95 1,460 445 1,500 1,268 60 1,328 172 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 400 160 240 150 60 90

Explanation / Answer

Operating Margin = Operating Income/Net Sales

For Year 2, Operating Margin = 445/1905 = 23.36%

Profit margin = Net Income/Sales

For year 1, Profit Margin = 90/1500 = 6%

Return on Total Assets = Net Income/TotalAssets

For Year 2, Return on Total Assets = 240/5639 = 4.26%

Return on Total Equity = Net Income/Total Equity

For Year 2, Return on Total Equity = 240/1875 (since company paid 100% of its earnings as dividend in Year 2, so no change in equity) = 12.8%

Basic Earnings Power =EBIT/Total Assets

For Year 1, Basic Earnings Power = 172/3,525 = 4.88%

Multiple Choice Question

Statement 1 and 3 are answers. They are correct statements.

Statement 2 and Statement 4 are incorrect clearly, because they talk about denominator of the respective rations (assets and common equity) increasing without change in numberator. This would lead to decline in ROA and ROE, respectively.

Statement 1 is correct Operating margin is EBIT/Net sales. Higher EBIT is a result of lower operating expenses or higher gross profit, which may be a result of higher prices or lower cost of goods sold.

Statement 3 is correct since the Operating Income (in operaying margin) and Net Income (in net profit margin) are differentiated by the interest and taxes paid by company. So if the net profit margin declines, even though operating margin has increased, clearly indicates higher taxes and interest payments made.

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