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.

Consider the following scenario:

Your boss has asked you to calculate the profitability ratios of Green Caterpillar Garden Supplies, Inc. and make comments on its second-year performance as compared to its first-year performance.

The following shows Green Caterpillars income statement for the last two years. The company had assets of $3,525,000 in the first year and $5,638,800 in the second year. Common equity was equal to $1,875,000 in the first year, 100% of earnings were paid out as dividends in the first year, and the firm did not issue new stock in the second year.

Green Caterpillar Garden Supplies, Inc.
Income Statement For the Year Ending December 31	Year 2	Year 1
Net Sales	$1,905,000	$1,500,000
Operating costs less depreciation and amortization	1,855,000	1,722,500
Depreciation and amortization	$95,250	$60,000
Total Operating Costs	1,950,250	1,782,500
Operating Income (or EBIT)	-$45,250	-$282,500
Less: Interest	-4,525	-22,600
Earnings before taxes (EBT)	-$40,725	-$259,900
Less: Taxes (40%)	-16,290	-103,960
Net Income	-$24,435	-$155,940

Calculate the profitability ratios of Green Caterpillar Garden Supplies, Inc. in the following table. Convert all calculations to a percentage rounded to two decimal places.

Ratio		Value
	Year 2	Year 1
Operating margin	(-14.83% or -2.86% or -2.38% 0r -3.02%)..........	-18.83%
Profit margin	-1.28% -8.19% 0r -14.04 or -1.63 or -10.40)	...........
Return on total assets	(-0.69% or -0.49% or -2.77% or -0.43%)............	-4.42%
Return on common equity	(-1.30% or -0.97% or -1.60% or -1.16%)..........	-8.32%
Basic earning power	-0.80%	(-8.01% or -6.01% or -1.28% or -5.01%)..........

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)A higher operating margin than the industry average indicates either lower operating costs, higher product pricing, or both.

(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.