Question

4. 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 Petroxy Oil Co. and make comments on its second-year performance as compared with its first-year performance.

The following shows Petroxy Oil Co.’s income statement for the last two years. The company had assets of $5,875 million in the first year and $9,398 million in the second year. Common equity was equal to $3,125 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.

Petroxy Oil Co. Income Statement For the Year Ending on December 31 (Millions of dollars)

	Year 2	Year 1
Net Sales	3,175	2,500
Operating costs except depreciation and amortization	1,365	1,268
Depreciation and amortization	159	100
Total Operating Costs	1,524	1,368
Operating Income (or EBIT)	1,651	1,132
Less: Interest	223	119
Earnings before taxes (EBT)	1,428	1,013
Less: Taxes (25%)	357	253
Net Income	1,071	760

Calculate the profitability ratios of Petroxy Oil Co. in the following table. Convert all calculations to a percentage rounded to two decimal places.

Ratio	Value
	Year 2	Year 1
Operating margin		45.28%
Profit margin	33.73%
Return on total assets		12.94%
Return on common equity		24.32%
Basic earning power	17.57%

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 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 profit margin is increasing.

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