4. Profitability ratios Aa Aa Summaries of the financial statements for Wilson E

Question

4. Profitability ratios Aa Aa Summaries of the financial statements for Wilson Electronics are shown below: Current assets Net fixed assets Total assets 3,000,000 12,000,000 15,000,000 Total debt Total equity Total debt & equity 6,000,000 9,000,000 15,000,000 Wilson generated $1,100,000 of net income on $31,000,000 of sales. Perform a DuPont analysis of Wilson's return on equity (ROE) below: ROE = Profit Margin x Total Assets Turnover Ratio x Equity Multiplier Wilson's president is happy with most areas of the firm's operations, but she thinks the firm's asset management can be improved. Specifically, she points out that the average total assets turnover ratio in the industry is 3.00x However, she doesn't want Wilson to be "average," so she wants it to strive for a total assets turnover ratio of 4.00x, which would be in line with the industry leaders. If Wilson succeeds in increasing its total assets turnover ratio without harming its other numbers, what would Wilson's new ROE be? Assume that this goal will be achieved without affecting other ratios O 32.48% 30.63% 33.33% O 28.57% 23.66% Suppose you are conducting ratio analysis for two firms in the same industry. You want to determine which firm is more profitable, but they have radically different capital structures: one is 100% equity-financed, and the other has a large amount of debt. Which profitability ratio will give you a better comparison of the firm's profitability by removing the effects of financing decisions? Basic earning power (BEP) O Return on equity (ROE) Return on assets (ROA)

Explanation / Answer

Part 1)

The value of Return on Equity is arrived as below:

Profit Margin = Net Income/Sales*100 = 1,100,000/31,000,000*100 = 3.55%

Total Asset Turnover Ratio = Sales/Total Assets = 31,000,000/15,000,000 = 2.07

Equity Multiplier = Total Assets/Total Equity = 15,000,000/9,000,000 = 1.67

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Notes:

1) Actual figures of profit margin, total asset turnover and equity multiplier have been used in the calculation. The rounded off figures have been used in the ROE only for representation purposes.

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Part 2)

The revised ROE is determined as below:

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Notes:

1) Actual figures of profit margin, total asset turnover and equity multiplier have been used in the calculation. The rounded off figures have been used in the ROE only for representation purposes.

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Part 3)

Basic Earning Power (BEP). [which is Option A]

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Explanation:

Basic earning power is calculated by dividing EBIT (earnings before interest and taxes) by total assets of the company. Since, EBIT is used in the determination of this ratio, any affect of financial leverage and taxes is not taken into account and therefore, effects of financing decisions are removed automatically.

ROE = Profit Margin X Total Assets Turnover Ratio X Equity Multiplier 12.22% = 3.55% X 2.07 X 1.67

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