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(Solved): 5. Profitability Ratios Profitability Ratios Help In The Analysis Of The Combined Impact Of Liquidi...

5. 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 Spandust Industries Inc. and make comments on its second-year performance as compared with its first-year performance.

The following shows Spandust Industries Inc.’s income statement for the last two years. The company had assets of $4,700 million in the first year and $7,518 million in the second year. Common equity was equal to $2,500 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.

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

Year 2

Year 1

Net Sales 2,540 2,000
Operating costs except depreciation and amortization 1,610 1,495
Depreciation and amortization 127 80
Total Operating Costs 1,737 1,575
Operating Income (or EBIT) 803 425
Less: Interest 80 34
Earnings before taxes (EBT) 723 391
Less: Taxes (25%) 181 98
Net Income 542 293

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



Year 2 Year 1
Operating margin    21.25%
Profit margin 21.34%   
Return on total assets    6.23%
Return on common equity    11.72%
Basic earning power 10.68%   

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 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.

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Expert Answer

Answer a. Year 2: Operating Margin = Operating Income / Net Sales Operating Margin = $803 / $2,540 Operating Margin = 31.61% Return on Total Assets = Net Income / Total Asset
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