Question

5. Profitability ratios 

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 Dernham Inc. and make comments on its second-year performance as compared with its first-year performance. 

The following shows Dernham Inc.'s income statement for the last two years. The company had assets of $10,575 million in the first year and $16,916 million in the second year. Common equity was equal to $5,625 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
Net Sales	5,715	4,500
Operating costs except depreciation and amortization	1,610	1,495
Depreciation and amortization	286	180
Total Operating Costs	1,896	1,675
Operating Income (or EBIT)	3,819	2,825
Less: Interest	382	226
Earnings before taxes (EBT)	3,437	2,599
Less: Taxes (40%)	1,375	1,040
Net Income	2,062	1,559

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
Operating margin		62.78%
Profit margin	36.08%
Return on total assets
Return on common equity		14.74%
Basic earning power	22.58%	27.72%

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 margin than the industry average indicates either lower operating costs, higher product pricing, or both. 

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

• An increase in the return on assets ratio implies an increase in the assets a firm owns. 

• If a company issues new common shares but its net income does not increase, return on common equity will increase.

Answer 1

Dernham Inc income statement
	year 2	year1
Net sales	5715	4500
operating expenses except depreciation	1610	1495
depricaition and amortisation	286	180
total operating costs	1896	1675
operating income(EBIT)	3819	2825
less: interest	382	226
Earnings before Taxes	3437	2599
Less taxes (40%)	1375	1040
net Income	2062	1559
Assets	16916	10575
common equity	5625	5625
Operating margin(operating income/ net sales)	66.82%	62.78%
Profit margin(net income/ net sales)	36.08%	34.64%
Return on total assets(net income/ total assets)	12.19%	14.74%
Return on equity(net income/ common equity)	36.66%	27.72%
Basic earning power(EBIT/ total Assets)	22.58%	26.71%
True About Profitabity Ratios
A higher operating margin than the industry average indicates either lower operating costs, higher product pricing, or both
If a company's operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes.
False About Profitabity Ratios
An increase in the return on assets ratio implies an increase in the assets a firm owns
If a company issues new common shares but its net income does not increase, return on common equity will increase
explanation
An increase in the return on assets ratio implies an increase in the income or decrease in assets
If a company issues new common shares but its net income does not increase, return on common equity will decrease