#1

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 Dernham Inc. and make comments on its second-year performance as compared with its first-year performance.

The following shows Dernham Inc. s income statement for the last two years. The company had assets of $3,525 million in the first year and $5,639 million in the second year. Common equity was equal to $1,875 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.

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

	Year 2	Year 1
Net Sales	1,905	1,500
Operating costs except depreciation and amortization	1,855	1,723
Depreciation and amortization	95	60
Total Operating Costs	1,950	1,783
Operating Income (or EBIT)	-45	-283
Less: Interest	-5	-37
Earnings before taxes (EBT)	-41	-246
Less: Taxes (40%)	-16	-98
Net Income	-25	-148

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

Ratio	Value
	Year 2	Year 1
Operating margin		-18.87%
Profit margin	-1.31%
Return on total assets		-4.20%
Return on common equity		-7.89%
Basic earning power	-0.80%

Decision makers and analysts look deeply into profitability ratios to identify trends in a companys 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. 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.

B. If a companys operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes.

C. An increase in a companys earnings means that the profit margin is increasing.

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

#2

Ratios are mostly calculated using data drawn from the financial statements of a firm. However, another group of ratios, called market value ratios, relate to a firms observable market value, stock prices, and book values, integrating information from both the market and the firms financial statements.

Consider the case of Green Caterpillar Garden Supplies Inc.:

Green Caterpillar Garden Supplies Inc. just reported earnings after tax (also called net income) of $9,250,000 and a current stock price of $12.00 per share. The company is forecasting an increase of 25% for its after-tax income next year, but it also expects it will have to issue 3,000,000 new shares of stock (raising its shares outstanding from 5,500,000 to 8,500,000).

If Green Caterpillars forecast turns out to be correct and its price/earnings (P/E) ratio does not change, what does the companys management expect its stock price to be one year from now? (Round any P/E ratio calculation to four decimal places.)

A. $9.71 per share

B. $12.00 per share

C. $7.28 per share

D. $12.14 per share

One year later, Green Caterpillars shares are trading at $55.80 per share, and the company reports the value of its total common equity as $16,507,000. Given this information, Green Caterpillars market-to-book (M/B) ratio is .

Can a companys shares exhibit a negative P/E ratio?

A. No

B. Yes

Which of the following statements is true about market value ratios?

A. Companies with high research and development (R&D) expenses tend to have low P/E ratios.

B. Companies with high research and development (R&D) expenses tend to have high P/E ratios.