Revision sheet of CLO2 & CLO5

Q1) Firm A has a Return on Equity (ROE) equal to 24%, while firm B has an ROE of 15% during
the same year. Both firms have a total debt ratio (D/V) equal to 0.8. Firm A has an asset
turnover ratio of 0.9, while firm B has an asset turnover ratio equal to 0.4. From this we
know that (Note: it is asking which of the firms has higher profit margin)

Firm A
ROE = 24% = 24/100 = 0.24
Debt ratio = 0.8
Asset turnover ratio = 0.9
ROE = Net income/Sales x Sales/Assets x Assets/Equity
0.24 = profit margin x 0.9 x 0.8
Let profit margin = Z
0.24 = Z x 0.9 x 0.8
0.24 = Z x 0.72
Z = 0.24/0.72
Profit margin = 0.3333
Profit margin = 0.3333 x 100
Profit margin = 33.33%

Firm B
ROE = 15% = 15/100 = 0.15
Debt ratio = 0.8
Asset turnover ratio = 0.4
ROE = Net income/Sales x Sales/Assets x Assets/Equity
0.15 = profit margin x 0.4 x 0.8
Let profit margin = Y
0.15 = Y x 0.4 x 0.8
0.15 = Y x 0.32
Y = 0.15/0.32
Profit margin = 0.46875
Profit margin = 0.46875 x 100
Profit margin = 46.88%
Firm B has a higher profit margin than firm A

Q2) Maryam Groups of Company has 2 subsidiaries, Legal Services and Real Estate.
The following are data from each subsidiary.

Legal Services
Income AED 900,000
Sales AED 560,000

Real Estate
Income 1,200,000
Sales 930,000

Which of the company would you say is better in terms of profitability?

Solution

Legal Services
Profit Margin (PM) = Income/Sales
PM = 900,000 / 560,000
PM = 1.6071
PM = 1.6071 x 100 = 160.71%

Real Estate
Profit Margin (PM) = Income/Sales
PM = 1,200,000 / 930,000
PM = 1.2903
PM = 1.2903 x 100 = 129.03%
Comment
The profit margin of Legal Services is higher and therefore, it is better.

Q3) XYZ Company reported the following return on equity (ROE).

 
Year 2019 2018
ROE 13.667% 13.653%

In 2020 XYZ Company reported the following.    

Profit margin 46.51%

Leverage ratio 0.68

Operating efficiency ratio   0.432

 Calculate the return on equity for 2020 and give your analysis on how XYZ did in 2020
in terms of ROE against its historical performance.

Answer

Return on equity (ROE) = Profit Margin x Return on Assets x Equity Multiplier (Leverage
ratio)
Profit Margin = 46.51% = 46.51/100 = 0.4651
ROE = 0.4651 x 0.432 x 0.68     
ROE = 0.13663       
ROE = 0.13663 x 100 = 13.663%     

Comment.
In general XYZ's performance is about similar across the years, however in 2020 XZY
was able to generate a bit more income for its shareholders than in 2018 but also a bit
less than in 2019