Profitability Ratios
You are analyzing the company's ability to generate revenues and profits, calculating the following things:
- the profit margin ratio,
- the rate of return on total assets,
- the asset turnover ratio,
- the rate of return on common stockholders’ equity, and
- earnings per share.
To calculate the profitability ratios for Lucky 7, Inc., you will need the following information from the company’s income statement and balance sheet. You will be calculating the profitability ratios for 2016.
Lucky 7, Inc.
Income Statement (Partial)
for the Years Ended
December 31 2015 and 2016
|
-
| 2016 | 2015 |
|---|
| Sales | $520,000 | $485,000 |
|---|
| Interest expense | $24,000 | $15,000 |
|---|
| Net income | $49,000 | $29,625 |
|---|
Lucky 7, Inc.
Comparative Balance Sheets (Partial)
December 31, 2016 and 2015
|
-
| 2016 | 2015 |
|---|
| Total assets | $644,000 | $408,500 |
|
-
|
-
|
-
|
| STOCKHOLDERS' EQUITY |
-
|
-
|
| Common stock, $5 par value | $150,000 | $100,000 |
| Additional paid-in capital | $116,000 | $66,300 |
| Treasury stock | ($12,500) | $0 |
| Total stockholders' equity | $364,500 | $232,300 |
Additional information:
- Shares of common stock outstanding on 12-31-2015, 20,000 shares
- Shares of common stock outstanding on 12-31- 2016, 29,000 shares
Profit Margin
The profit margin measures the amount of net profit earned as a percentage of total sales (or net sales). This was calculated when you prepared the vertical analysis. Profit margin is calculated as follows:
- profit margin (2016) = net income / net sales
- profit margin = $49,000 / $520,000
- profit margin = 9.42%
Rate of Return on Total Assets
The return on total assets measures how efficiently the company has used its assets to produce income. The rate of return on total assets is calculated as follows:
- rate of return on total assets (2016) = (net income + interest expense) / average total assets
- rate of return on total assets = ($49,000 + $24,000) / (($644,000 + $408,500) / 2)
- rate of return on total assets = $73,000 / $526,250
- rate of return on total assets = 13.87%
Asset Turnover Ratio
The asset turnover ratio measures how efficiently a business uses its average total assets to generate sales. The asset turnover ratio is calculated as follows:
- asset turnover (2016) = net sales / average total assets
- asset turnover = $520,000 / (($644,000 + $408,500) / 2)
- asset turnover = $520,000 / $526,250
- asset turnover = 0.99 times
Rate of Return on Common Stockholders’ Equity
The return on common stockholders' equity measures the relationship of the net income that is available to common stockholders to the common stockholders’ equity. The rate of return on common stockholders’ equity is calculated as follows:
- rate of return on common stockholders’ equity (2016) = (net income - preferred dividends) / average common stockholders’ equity assets
- rate of return on common stockholders’ equity = ($49,000 - $0) / (($364,500 + $232,300) / 2)
- rate of return on common stockholders’ equity = $49,000 / $298,400
- rate of return on common stockholders’ equity = 16.42%
Note: Lucky 7 did not issue preferred stock and therefore did not pay a preferred dividend.
Earnings Per Share (EPS)
Earnings per share measures the amount of net income earned for each share of common stock outstanding. Earnings per share is calculated as follows: Note: This formula does not appear in the textbook.
- EPS (2016) = (net income - preferred dividends) / weighted average number of shares of common stock outstanding
- EPS = ($49,000 - $0) / ((29,000 + 20,000) / 2)
- EPS = $49,000 / 24,500 shares
- EPS = $2.00 per share
Lucky 7 did not issue preferred stock and therefore did not pay a preferred dividend.
Note: For simplicity, the weighted average number of shares of common stock outstanding was determined as follows: number of shares outstanding on December 31, 2015, plus the number of shares outstanding on December 31, 2016, divided by two.
(29,000 shares outstanding + 20,000 shares outstanding) / 2
49,000 shares / 2
= 24,500 shares
