Question

11. 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.

Consider the following scenario:

Your boss has asked you to calculate the profitability ratios of Cute Camel Woodcraft Company and make comments on its second-year performance as compared to its first-year performance.

The following shows Cute Camel’s income statement for the last two years. The company had assets of $5,875,000 in the first year and $9,398,000 in the second year. Common equity was equal to $3,125,000 in the first year, 100% of earnings were paid out as dividends in the first year, and the firm did not issue new stock in the second year.

Cute Camel Woodcraft Company
Income Statement For the Year Ending December 31	Year 2	Year 1
Net Sales	$3,175,000	$2,500,000
Operating costs less depreciation and amortization	1,610,000	1,495,000
Depreciation and amortization	$158,750	$100,000
Total Operating Costs	1,768,750	1,595,000
Operating Income (or EBIT)	$1,406,250	$905,000
Less: Interest	189,844	95,025
Earnings before taxes (EBT)	$1,216,406	$809,975
Less: Taxes (40%)	486,562	323,990
Net Income	$729,844	$485,985

Calculate the profitability ratios of Cute Camel Woodcraft Company in the following table. Convert all calculations to a percentage rounded to two decimal places.

Ratio		Value
	Year 2	Year 1
Operating profit margin		36.20%
Net profit margin	22.99%
Return on total assets		8.27%
Return on common equity		15.55%

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.

If a company has a net 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.

An increase in a company’s earnings means that the net profit margin is increasing.

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

Answer 1

Profitability ratio Operating profit Margin Net Profit Margin Formula EBT/Net sales | Net Income/Net sales 59% 99% Year Comments 36,20% Operating profit Morgia ratio increases in year 2. It is good for company growth 19,44% operating Net Margin ratio increases in year 2. It is good for company growth. Return on Total Assets ratio decreases in year 2. It means company return against total 8.27% assets is decrease Return on Equity ratio increases in year 2. It means company return against Equity is Return on Total Assets Net Income/Total Assets 117.77% Net Income/value of Return on common equity com 1 If the company has a net profit margin of 10%, yes it means that the company earned a net income of $0.10 for each $ of sales 2 If the company operating profit margin Increases but it profit margin decreases yes it is true it could mean that the company paid more interest and Taxes. 3 Yes it is true an increase in a company's earning means that the net profit margin is increasing 4 If a company issues new common shares but its net income does not increase then return on common equity will decrease instead of increase