Question

Gadget Twin Inc. Income Statement For the Year Ending on December 31 (Millions of dollars)

	Year 2	Year 1
Net Sales	6,350	5,000
Operating costs except depreciation and amortization	1,120	1,040
Depreciation and amortization	318	200
Total Operating Costs	1,438	1,240
Operating Income (or EBIT)	4,912	3,760
Less: Interest	663	395
Earnings before taxes (EBT)	4,249	3,365
Less: Taxes (40%)	1,700	1,346
Net Income	2,549	2,019

Calculate the profitability ratios of Gadget Twin Inc. in the following table. Convert all calculations to a percentage rounded to two decimal places.

Ratio	Value
	Year 2	Year 1
Operating margin		75.20%
Profit margin	40.14%
Return on total assets		17.18%
Return on common equity		32.30%
Basic earning power	26.13%

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

Operating Margin = Operating Income/Net Sales

Year 2 = 4912/6350

= 77.35%

Profit Margin = Net Income/Net Sales

Year 1 = 2019/5000

= 40.38%

Return on Total Assets = Net Income/Assets

Return on Equity = Net Income/Equity

Year 2 = 2549/6251

= 40.78%

BEP = EBIT/Total Assets

The correct statements are:

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.

If equity increases and income does not, ROE will fall

If return on assets increases, assets will not increase