3. 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 St. McStanky Beer Co. and make comments on its second-year performance as compared with its first-year performance.

The following shows St. McStanky Beer 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.

St. McStanky Beer 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	1,610	1,495
Depreciation and amortization	159	100
Total Operating Costs	1,769	1,595
Operating Income (or EBIT)	1,406	905
Less: Interest	190	72
Earnings before taxes (EBT)	1,216	833
Less: Taxes (25%)	304	208
Net Income	912	625

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

Ratio	Value
	Year 2	Year 1
Operating margin		36.20%
Profit margin	28.72%
Return on total assets		10.64%
Return on common equity		20.00%
Basic earning power	14.96%

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.

1.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.

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

3. An increase in the return on assets ratio implies an increase in the assets a firm owns.

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