Chapter 15, Problem 22P

Problem 9-20A Return on investment

Sorrento Corporation’s balance sheet indicates that the company has $500,000 invested in operating assets. During 2018, Sorrento earned operating income of $50,000 on $1,000,000 of sales.

Required

1. a. Compute Sorrento’s profit margin for 2018.
2. b. Compute Sorrento’s turnover for 2018.
3. c. Compute Sorrento’s return on investment for 2018.
4. d. Recompute Sorrento’s ROI under each of the following independent assumptions:
   1. (1) Sales increase from $1,000,000 to $1,200,000, thereby resulting in an increase in operating income from $50,000 to $56,000.
   2. (2) Sales remain constant, but Sorrento reduces expenses, resulting in an increase in operating income from $50,000 to $52,000.
   3. (3) Sorrento is able to reduce its invested capital from $500,000 to $400,000 without affecting operating income.

To determine

Calculate the profit margin of Corporation S.

Explanation of Solution

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

Formula of operating profit margin:

$\text{Operating profit margin}=\frac{\text{Operating income}}{\text{Sales}}$

Calculate the profit margin of Corporation S, if operating income is $50,000 and sales is $1,000,000.

$\begin{array}{c}\text{Operating profit margin =}\frac{\text{Operating income}}{\text{Sales}}\\ \text{= }\frac{\text{\$50,000}}{\text{\$1,000,000}}\\ \text{= 0}\text{.05 or 5\%}\end{array}$

Conclusion

Thus, the profit margin of Corporation S is 5%.

To determine

Calculate the turnover of Corporation S.

Explanation of Solution

Investment turnover: This ratio gauges the operating efficiency by quantifying the amount of sales generated from the assets invested.

Formula of investment turnover:

$\text{Investment turnover}=\frac{\text{Sales}}{\text{Operating assets}}$

Calculate the turnover of Corporation S, if operating assets is $500,000 and sales is $1,000,000.

$\begin{array}{c}\text{Turnover =}\frac{\text{Sales}}{\text{Operating assets}}\\ \text{= }\frac{\text{\$1,000,000}}{\text{\$500,000}}\\ \text{= 2 times}\end{array}$

Conclusion

Thus, the turnover of Corporation S is 2 times.

To determine

Calculate the return on investment (ROI) of Corporation S.

Explanation of Solution

Calculate the ROI of Corporation S, if operating income is $50,000, and operating assets are $1,000,000.

$\begin{array}{c}\text{Return on investment = }\frac{\text{Operating income}}{\text{Operating assets}}\\ \text{=}\frac{\text{\$50,000}}{\text{\$5,000,000}}\\ \text{= 0}\text{.1 or 10\%}\end{array}$

Conclusion

Thus, the ROI of Corporation S is 10%.

To determine

Calculate the ROI of Corporation S, if operating income increases to $56,000, and sales increases to $1,200,000.

Explanation of Solution

Formula of ROI according to DuPont formula:

$\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Operating income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Operating assets}}\\ \text{=}\frac{\text{Operating income}}{\text{Operating assets}}\end{array}$

Calculate the ROI of Corporation S, if operating income increases to $56,000, sales increases to $1,200,000, and operating assets remain at $500,000.

$\begin{array}{c}\text{Return on investment =Profit margin × Investment turnover}\\ \text{=}\frac{\text{Operating income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Operating assets}}\\ =\frac{\$56,000}{\$1,200,000}\times \frac{\$1,200,000}{\$500,000}\\ \text{= }4.67\%\times 2.4\\ \text{= 0}\text{.11208 or 11}\text{.21\%}\end{array}$

Conclusion

Thus, ROI of Corporation S is 11.21%.

To determine

Calculate the ROI of Corporation S, if operating income increases to $52,000.

Explanation of Solution

Calculate the ROI of Corporation S, if operating income increases to $52,000, sales remain at $1,000,000, and operating assets remain at $500,000.

$\begin{array}{c}\text{Return on investment =Profit margin × Investment turnover}\\ \text{=}\frac{\text{Operating income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Operating assets}}\\ =\frac{\$52,000}{\$1,000,000}\times \frac{\$1,000,000}{\$500,000}\\ \text{= }5.2\%\times 2\\ \text{= 0}\text{.104 or 10}\text{.4\%}\end{array}$

Conclusion

Thus, ROI of Corporation S is 10.4%.

To determine

Calculate the ROI of Corporation S, if operating assets decreases to $400,000.

Explanation of Solution

Calculate the ROI of Corporation S, if operating assets decreases to $400,000, sales remain at $1,000,000, and operating income remains at $50,000.

$\begin{array}{c}\text{Return on investment =Profit margin × Investment turnover}\\ \text{=}\frac{\text{Operating income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Operating assets}}\\ =\frac{\$50,000}{\$1,000,000}\times \frac{\$1,000,000}{\$400,000}\\ \text{= }5\%\times 2.5\\ \text{= 0}\text{.125 or 12}\text{.5\%}\end{array}$

Conclusion

Thus, ROI of Corporation S is 12.5%.