Question

Which ratio would be best to compare three companies in terms of how well they are managing their expenses?

Assume the three firms are in the same industry, produce similar products and are similar in nature to each other (ex: Nike vs Underarmour, etc...)

(look through the below ratios in your notes/formula sheet/book so you understand what they are trying to measure)

Multiple Choice

• Return on Equity

• Profit Margin

• Interest Coverage Ratio (Times interest Earned)

• Equity Multiplier

Answer 1

Return on equity indicates the percentage of net income earned by company on shareholder's equity. It is used to determine the profitability of shareholders' wealth. Thus, option (a) is incorrect as it does not indicate whether company is managing its expenses well.

Interest coverage ratio determines company's ability to repay its interest obligation from its earnings earned during the period. It indicates on payment of interest and not expenses. Thus, option (b) is incorrect.

Equity multiplier indicates proportion of equity used to finance assets of business. It does not include expenses in calculating the ratio and thus option (d) is incorrect.

The correct answer is profit margin. Profit margin indicates profitability of business from its business operation. Profit margin is calculated as net profit divided by sales revenue and thus if net profit margin is higher then it would indicate company is either managing its expenses well or able to generate higher revenue. Thus, option (c) is correct.