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 Randall and Arts Inc. and make comments on its second-year performance as compared to its first-year performance.

The following shows Randall and Arts Inc.s income statement for the last two years. The company had assets of $11,750 million in the first year and $18,796 million in the second year. Common equity was equal to $6,250 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.

Randall and Arts Inc.

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

	Year 2	Year 1
Net Sales	6,350	5,000
Operating costs except depreciation and amortization	1,120	1,040
Depreciation and amortization	318	200
Total Operating Costs	1,438	1,240
Operating Income (or EBIT)	4,912	3,760
Less: Interest	491	489
Earnings before taxes (EBT)	4,421	3,271
Less: Taxes (40%)	1,768	1,308
Net Income	2,653	1,963

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

Ratio	Value
	Year 2	Year 1
Operating margin		75.20%
Net profit margin	41.78%
Return on total assets		16.71%
Return on common equity		31.41%
Basic earning power	26.13%

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

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

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

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

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