Question

1.) Luna Lighting, a retail firm, has experienced modest sales growth over the past three years buy has had difficulty translating the expansion of sales into improved profitability. Using three years’ financial statements, you have developed the following ratio calculations and industry comparisons. Based on this information, suggest possible reasons for Luna’s profitability problems.

                                                         2016             2015           2014      Industry Averages 2016

Current                                             2.3X              2.3X            2.2X                  2.1X

Average collection period           45 days          46 days       47 days               50 days

Inventory turnover                            8.3X              8.2X            8.1X                   8.3X

Fixed asset turnover                         2.7X              3.0X            3.3X                   3.5X

Total asset turnover                          1.1X              1.2X            1.3X                    1.5X

Debt ratio                                          50%               50%             50%                54%

Times interest earned                      8.1X   8.2X            8.1X                     7.2X

Fixed charge coverage                     4.0X               4.5X            5.5X                     5.1X

Gross profit margin                          43%                 43%             43%                     40%

Operating profit margin                    6.3%               7.2%            8.0%                     7.5%

Net profit margin                              3.5%                4.0%             4.3%               4.2%

Return on assets                              3.7%               5.0%              5.7%                      6.4%

Return on equity                               7.4%   9.9%            11.4%                     11.8%

Answer 1

Profitability of a company can be explained from ratios below:

Gross profit margin=Gross profit/sales

Operating profit margin=operating profit/sales

Net profit margin=Net income/sales

Return on assets=Net income/Assets= Net profit margin*asset turnover

Return on Equity= Net income/Equity=Net profit margin*asset turnover* equity multiplier

We can see that operating profit margin is decreasing year on year from 8% to 6.3% but the gross profit margin remain same and it means the operating expenses are increasing but the sales growth remained same . Net profit margin also decreasing and it may be due to reduction in operating margin

Return on assets tells how efficiently company using its assets to generate income and we can see that it is also reducing year on year from 5.7% to 3.7% which is quite less compared to industry average. The reason can be told based on total asset turnover which is reducing

Return on equity is also decreasing year on year which is due to reduction in the net profit margin and asset turnover as we can see that equity multiplier=(1+debt ratio) is remaining same year on year