6.

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 Blur Corp. and make comments on its

second-year performance as compared to its first-year performance.

The following shows Blur Corp.’s income statement for the last two years. The company had assets of

$10,575 million in the first year and $16,916 million in the second year. Common equity was equal to

$5,625 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.

Blur Corp.

 Income Statement For the Year Ending on December 31 (Millions of dollars)

Year
2 Year 1
Net Sales 5,715 4,500
 Operating costs except depreciation and amortization 1,855 1,723
 Depreciation and amortization 286 180
Total Operating Costs 2,141 1,903
Operating Income (or EBIT) 3,574 2,597
Less: Interest 357 273
Earnings before taxes (EBT) 3,217 2,324
Less: Taxes (40%) 1,287 930
Net Income 1,930 1,394
Calculate the profitability ratios of Blur Corp. in the following table. Convert all calculations to a

percentage rounded to two decimal places.

Value
Ratio Year 2 Year 1
Operating margin 57.71%
62.54%    
Net profit margin 33.77%
30.98%    
Return on total assets 13.18%
11.41%    
Return on common 24.78%
34.31%    
 Value
Ratio Year 2 Year 1
equity
Basic earning power 21.13%
24.56%    
Points:
1/1

Close Explanation

Explanation:

Profitability ratios will help you determine the company’s ability to generate earnings compared to the

expenses and other costs incurred to support these earnings. Calculate the ratios for Blur Corp. by

using the numbers given in the previous table:

Blur Corp. Ratio Calculations

Ratio Formula Year 2 Year 1

Operating Margin = EBIT / Sales = 62.54% 57.71%
Net profit margin = Net Income / Sales = 33.77% 30.98%
Return on Total Assets = Net Income / Total Assets = 11.41% 13.18%
Return on Common = Net Income / Common Equity = 34.31% 24.78%
Equity
Basic Earning Power = EBIT / Total Assets = 21.13% 24.56%
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 net profit margin is increasing.

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

common equity will increase.

Points:
1/1

Close Explanation

Explanation:
Operating margin is the ratio of a company’s operating income, or earnings before interest and taxes

(EBIT), and its sales. If the operating margin is high, it is probably because of either higher product

prices, which will lead to increased sales revenues, or lower operating costs, or both. Higher sales,

lower costs, or both will lead to a higher operating margin. However, note that the ability to charge a

higher product price is constrained by competition, so generally a higher operating margin would imply

that the company was able to cut costs rather than charge more for its products.

If a firm’s earnings (net income) rise by 10% while its sales rise by 15%, the net profit margin (net

income divided by sales) will actually decrease. If the company’s costs and expenses increase at a

faster rate than the rate at which sales are increasing, profit margin will in fact decrease. So, although

the company increased its net income, it also has diminished its profit margins.

An increase in the operating margin would mean that either sales increased, operating costs

decreased, or both. However, if the net profit margin decreased, it would mean that higher deductions

were made from the operating income. (Refer to the preceding income statement.) These deductions

could either be higher interest expenses or higher taxes. Thus, if a company’s operating margin

increased but its net profit margin decreased, it could mean that the company paid more in interest or

taxes.

Return on common equity (ROE) is the ratio of net income and a company’s common equity. If a

company issues new common shares, its total shares outstanding will increase, which means that the

equity base (denominator in the ROE ratio) increases. Net income staying the same will now be

available for a larger number of common equity claims, thus leading to a decline in the company’s

ROE.