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 to its first-year performance. The following shows Dernham Inc.'s income statement for the last two years. The company had assets of $7,050 million in the first year and $11,278 million in the second year. Common equity was equal to $3,750 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) Net Sales 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 Year 2 3,810 1,365 191 1,556 2,254 304 1,950 780 1,170 Year 1 3,000 1,268 120 1,388 1,612 129 1,483 593 890

Answer 1

Answer a.

Year 2:

Operating Margin = Operating Income / Net Sales
Operating Margin = $2,254 / $3,810
Operating Margin = 59.16%

Return on Total Assets = Net Income / Total Assets
Return on Total Assets = $1,170 / $11,278
Return on Total Assets = 10.37%

Return on Common Equity = Net Income / Total Common Equity
Return on Common Equity = $1,170 / $3,750
Return on Common Equity = 31.20%

Year 1:

Profit Margin = Net Income / Net Sales
Profit Margin = $890 / $3,000
Profit Margin = 29.67%

Basic Earning Power = Operating Income / Total Assets
Basic Earning Power = $1,612 / $7,050
Basic Earning Power = 22.87%

Answer b.

If a company has a profit margin of 10%, it means that the company earned a net income of $0.10 for each dollar of sales.
If a company’s operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes.