Question

Padgett Company has compiled the following data:

Net sales revenue $1,000,000

Operating income 60,000

Average total assets 400,000

Management’s target rate of return 12%

Compute the following amounts for Padgett:

1. Profit margin ratio
2. Asset turnover ratio
3. Return on investment
4. Residual income

Short answer

The profit margin ratio of the company is6%.

The asset turnover ratio is2.5 times.

Return on investment is15%.

Residual income of the company is$12,000.

Step-by-step solution

Meaning of Operating income

Operating income refers to the income generated by a business concern from its core operations. It is computed by taking the difference betweensales revenue and associated costs such as variable and fixed.

Computation of profit margin ratio

$\begin{array}{rcl}\mathit{P}\mathit{r}\mathit{o}\mathit{f}\mathit{i}\mathit{t}\mathbf{}\mathit{m}\mathit{a}\mathit{r}\mathit{g}\mathit{i}\mathit{n}\mathbf{}\mathit{r}\mathit{a}\mathit{t}\mathit{i}\mathit{o}& \mathbf{=}& \frac{\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}}{\mathbf{N}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{s}\mathbf{a}\mathbf{l}\mathbf{e}\mathbf{s}}\mathbf{\times }\mathbf{100}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{60}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}}\mathbf{\times }\mathbf{100}\\ & \mathbf{=}& \mathbf{6}\mathbf{\%}\end{array}$

Computation of asset turnover ratio

$\begin{array}{rcl}\mathit{A}\mathit{s}\mathit{s}\mathit{e}\mathit{t}\mathbf{}\mathit{t}\mathit{u}\mathit{r}\mathit{n}\mathit{o}\mathit{v}\mathit{e}\mathit{r}\mathbf{}\mathit{r}\mathit{a}\mathit{t}\mathit{i}\mathit{o}& \mathbf{=}& \frac{\mathbf{N}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{s}\mathbf{a}\mathbf{l}\mathbf{e}\mathbf{s}}{\mathbf{A}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{g}\mathbf{e}\mathbf{}\mathbf{t}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{a}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{400}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{2}\mathbf{.}\mathbf{5}\mathbf{}\mathit{t}\mathit{i}\mathit{m}\mathit{e}\mathit{s}\end{array}$

Computation of return on investment

$\begin{array}{rcl}\mathit{R}\mathit{e}\mathit{t}\mathit{u}\mathit{r}\mathit{n}\mathbf{}\mathit{o}\mathit{n}\mathbf{}\mathit{i}\mathit{n}\mathit{v}\mathit{e}\mathit{s}\mathit{t}\mathit{m}\mathit{e}\mathit{n}\mathit{t}& \mathbf{=}& \frac{\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}}{\mathbf{A}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{g}\mathbf{e}\mathbf{}\mathbf{t}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{a}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}}\mathbf{\times }\mathbf{100}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{60}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{400}\mathbf{,}\mathbf{000}}\mathbf{\times }\mathbf{100}\\ & \mathbf{=}& \mathbf{15}\mathbf{\%}\end{array}$

Computation of residual income

$\begin{array}{rcl}\mathit{R}\mathit{e}\mathit{s}\mathit{i}\mathit{d}\mathit{u}\mathit{a}\mathit{l}\mathbf{}\mathit{i}\mathit{n}\mathit{c}\mathit{o}\mathit{m}\mathit{e}& \mathbf{=}& \mathit{O}\mathit{p}\mathit{e}\mathit{r}\mathit{a}\mathit{t}\mathit{i}\mathit{n}\mathit{g}\mathbf{}\mathit{i}\mathit{n}\mathit{c}\mathit{o}\mathit{m}\mathit{e}\mathbf{-}\left(Targetrateofreturn\times Averagetotalassets\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{60}\mathbf{,}\mathbf{000}\mathbf{-}\left(12\%\times \$400,000\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{60}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{48}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{\$}\mathbf{12}\mathbf{,}\mathbf{000}\end{array}$