Chapter 12, Problem 6E

1.

To determine

Compute the profitability ratios of Company AE.

Answer to Problem 6E

Financial Ratios: Financial ratios are the metrics used to evaluate the liquidity, capabilities, profitability, and overall performance of a company. The profitability ratios are:

• Gross profit ratio: 36.56%
• Return on assets: 20%
• Profit margin: 8.80%
• Asset Turnover: 2.27 times
• Return on equity: 40.38%

Explanation of Solution

Gross profit ratio: Gross profit is the financial ratio that shows the relationship between the gross profit and net sales. It represents gross profit as a percentage of net sales. Gross Profit is the difference between the net sales revenue, and the cost of goods sold. It can be calculated by dividing gross profit and net sales.

Formula:

$\text{Gross profit ratio}=\frac{\text{Gross profit }}{\text{Net sales}}\times 100$

Determine gross profit ratio.

Given: Company AE reports sales of $19,310,000.

$\begin{array}{c}\text{Gross profit ratio}=\frac{\text{Gross profit }}{\text{Net sales}}\times 100\\ =\frac{\text{\$7,060,000}\left(1\right)}{\text{\$19,310,000 }}\times 100\\ =36.56\%\end{array}$

Working Note:

Determine the amount of gross profit.

$\begin{array}{c}\text{Gross profit}=\text{Net sales}-\text{Cost of goods sold}\\ =\text{\$19,310,000}-\text{\$12,250,000}\\ =\$7,060,000\end{array}$ (1)

Return on assets: Return on assets determines the particular company’s overall earning power. It is determined by dividing sum of net income and average total assets.

Formula:

$\text{Return on assets}=\frac{\text{Net}\text{income }}{\text{Average total assets}}\times 100$

Determine return on assets ratio.

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net}\text{income }}{\text{Average total assets}}\times 100\\ =\frac{\$1,700,000}{\$8,500,000\text{ (2)}}\\ =20\%\end{array}$

Working Note:

Determine the amount of average total assets.

$\begin{array}{c}\text{Average total assets}=\frac{\text{Opening total assets }+\text{Closing total assets }}{\text{2}}\\ =\frac{\$7,800,000+\$9,200,000}{2}\\ =\frac{\$17,000,000}{\text{2}}\\ =\$8,500,000\end{array}$ (2)

Profit margin: This ratio gauges the operating profitability by quantifying the amount of income earned from business operations from the sales generated.

Formula:

$\begin{array}{l}\text{Profit margin}=\frac{\text{Net}\text{income }}{\text{Net sales}}\times 100\\ \end{array}$

Determine profit margin ratio.

Given: Company AE reports sales of $19,310,000 and net income of $1,700,000.

$\begin{array}{c}\text{Profit margin}=\frac{\text{Net}\text{income }}{\text{Net sales}}\times 100\\ =\frac{\$1,700,000}{\$19,310,000}\times 100\\ =8.80\%\end{array}$

Asset Turnover: Asset turnover refers to the ratio calculated which determines the amount of sales revenue generated by the business with the use of the total assets owned by it.

Formula:

$\begin{array}{l}\text{Asset turnover}=\frac{\text{Net}\text{sales }}{\text{Average total assets}}\times 100\\ \end{array}$

Determine asset turnover ratio.

Given: Company AE reports sales of $19,310,000, opening and closing balance of total assets amounts to $7,800,000 and $9,200,000 respectively.

$\begin{array}{c}\text{Asset turnover}=\frac{\text{Net}\text{sales }}{\text{Average total assets}}\times 100\\ =\frac{\$19,310,000}{\$8,500,000\text{ (3)}}\\ =2.27\text{ times}\end{array}$

Working Note:

Determine the amount of average total assets.

$\begin{array}{c}\text{Average total assets}=\frac{\text{Opening total assets }+\text{Closing total assets }}{\text{2}}\\ =\frac{\$7,800,000+\$9,200,000}{2}\\ =\frac{\$17,000,000}{\text{2}}\\ =\$8,500,000\end{array}$ (3)

Return on equity: Return on equity is used to determine the relationship between the net income and the average common equity that are invested in the company.

Formula:

 $\text{Return on stockholders' equity }=\frac{\text{Net income}}{\text{Average stockholder’s equity}}$

Determine return on stockholders’ equity ratio.

Given: Company AE reports net income of $1,700,000.

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net}\text{income }}{\text{Average stockholders' equity}}\times 100\\ =\frac{\$1,700,000}{\$4,210,000\text{ (6)}}\\ =40.38\%\end{array}$

Working Note:

Determine the amount of average stockholders’ equity.

$\begin{array}{c}\text{Average stockholder’s equity}=\frac{\left(\begin{array}{l}\text{Opening }\\ \text{stockholder’s }\\ \text{equity}\end{array}\right)+\left(\begin{array}{l}\text{Closing }\\ \text{stockholder’s}\\ \text{ equity}\end{array}\right)}{\text{2}}\\ =\frac{\$3,540,000+\$4,880,000}{\text{2}}\\ =\frac{\$8,420,000}{\text{2}}\\ =\$4,210,000\end{array}$ (6)

Compute the amount of opening and closing stockholders’ equity.

$\begin{array}{c}\text{Opening stockholders' equity}=\text{Common stock}+\text{Retained earnnings}\\ \text{=\$1,900,000}+\text{\$1,640,000}\\ \text{=\$3,540,000}\end{array}$ (4)

$\begin{array}{c}\text{Closing stockholders' equity}=\text{Common stock}+\text{Retained earnnings}\\ \text{=\$1,900,000}+\text{\$2,980,000}\\ \text{=\$4,880,000}\end{array}$ (5)

2.

To determine

Explain whether the company is more profitable or less profitable based on the given industry average.

Explanation of Solution

Comparison between industry average and company’s performance:

Ratios	Industry average	Company AE’s Performance
Gross profit ratio	45%	36.56%
Return on assets	25%	20%
Profit margin	15%	8.80%
Asset Turnover	2.5 times	2.27 times
Return on equity	35%	40.38%

Table (1)

Company AE is less profitable as its profitability is lower than the industry average in every aspect, except in return on equity, where the ratio is better than the industry average.