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 Triptych Food Corp. and make comments on its second-year performance as compared with its first-year performance. The following shows Triptych Food Corp.’s income statement for the last two years. The company had assets of $9,400 million in the first year and $15,037 million in the second year. Common equity was equal to $5,000 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.
Gadget Twin Inc.
Income Statement
For the Year Ending on December 31
(Millions of dollars)
Year 2 Year 1
Net Sales 5715 4500
Operating costs except
depreciation and amortization 1855 1723
Depreciation and amortization 286 180
Total Operating Costs 2141 1903
Operating Income (or EBIT) 3574 2597
Less: Interest 357 338
Earnings before taxes (EBT) 3217 2259
Less: Taxes (40%) 1287 904
Net Income 1930 1355
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 57.71%
Profit margin 33.77%
Return on total assets 12.81%
Return on common equity 24.09%
Basic earning power 21.13%
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.
a. A higher operating margin than the industry average indicates either lower operating costs, higher product pricing, or both.
b. If a company's operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes.
c. An increase in the return on assets ratio implies an increase in the assets a firm owns.
d. If a company issues new common shares but its net income does not increase, return on common equity will increase.