Question

What impact would borrowing an additional $20,000 to buy more equipment have on each of the ratios in (a) above, assuming that no changes are expected on the income statement and balance sheet? 1. Current ratio 2. Debt to assets 3. Gross profit rate 4. Profit margin 5. Return on assets 6, Return on common stockholders equity SUBNIT ANSWER /3V2019

Answer 1

The following answer by has been arrived at assuming that the borrowing of $20000 is a long term debt and that the equipment purchases is a fixed asset.

1) Current Ratio

current ratio=current assets/current liabilities

As you can see current ratio deals with current items rather than long term items in the balance sheet. Therefore the transaction involving purchase of equipment(long term asset) by taking a long term debt has no effect on current assets or current liabilities, hence no effect on the current ratio either.

2) Debt to assets ratio

Debt to assets ratio=(short term debt+ long term debt)/ total assets

As can be seen in the formula, a change in the long term debt and assets can affect the debt to assets ratio. Here the new equipment bought will result in an increase in fixed assets by $20000 and a simultaneous increase long term debt by $20000 also. If the debt to assets ratio was greater than 1 before this transaction, the ratio will decrease. If it was less than 1 before the transaction, the ratio will increase. If it was 1, it will remain the same. This is only a prediction arrived at with simple math by taking virtual figures.

There are other formulas for debt to assets ratio but irrespective of the formulas used, the impact will be the same.

3) Gross profit rate

It is given in the question itself that this transaction will not have impact on the income statement and therefore assuming there is no increase in productivity, gross profit rate remains the same. If the productivity increases, the gross profit rate might increase.

4) Profit margin

The profit margin is arrived at after reducing finance charges from gross profit. An increase in long term debt will result in additional interest and an increase in equipment will result in an increase in yearly depreciation, thereby reducing three profit margin. This conclusion stands assuming productivity is constant.

5) Return on assets

return on assets=net income/total assets

As seen above, the transaction will result in a decrease in profit margin, ie, net income will decrease and there will also be an increase in total assets because new equipment is bought. This will have the effect of decreasing the return on assets ratio.

6) Return on common stockholders equity

= (Net income-preference dividend)/average common stockholders equity

There is no change in equity resulting from the transaction. Only change is the decrease in net income. This will have the impact of reducing the return on common stockholders equity. However the decrease will be of a lesser magnitude than return on assets.