Question

You've been asked to tutor Tyler, a finance student who doesn't feel comfortable about his understanding of the relationship between a company's business activities, its financial accounts, and the company's financial ratios. To better appreciate these relationships, you've created the following exercises for Tyler to complete. The purpose of these exercises is to help Tyler (1) understand the effect of business transactions on financial statement-such as balance sheet and income statement-accounts and (2) how these changes in the numerators and denominators of financial ratios affect the ratios' values. However, before using these exercises in your tutoring session later today, you'll want to run the calculations on the following two business transactions, to verify the accuracy of your answers. To provide a consistent frame of reference for the company's financial statements and ratios, assume that the following balance sheet and income statement reflect the company's pretransaction condition and performance. Lancashire Railway Co.'s Pretransaction Statement of Financial Condition Cash $15,000 Accounts payable $20,000 Marketable securities Wages payable 20,000 10,000 470,000 Accounts receivable 10,000 Taxes payable Notes payable Inventory 500,000 50,000 Prepaid expenses 5,000 Total current liabilities 100,000 Total current assets 1,000,000 Long-term debt 500,000 Total liabilities 600,000 Gross plant and equipment 1,500,000 Common stock 150,000 Accumulated depreciation 500,000 Capital paid in excess of par 350,000 Net plant and equipment 1,000,000 Retained earnings 900,000 Total equity 1,400,000 Total assets $2,000,000 Total debt and equity $2,000,000

Answer 1

Transaction 1

when company issues shares above the par value following journal entiry is passed:

Cash (25000 shares X $20)	500000
To Common stock (25000 shares X $1)		25000
To Paid-In Capital in Excess of Par Value—Common (25000 shares X $19)		475000
(being issuance of 25000 shares)

From the above its very evident that the following accounts will get impacted

Cash - it will increase

Common stock - it will increase

Capital paid-in excess of par - it will increase

Only those will be impacted which has cash and capital contribution as part of their calculaction

inventory turnover

cost of goods sold / average inventory

no change - as cash or capital is not part of the formula

debt ratio	total liabilities / total assets
	before	after
total liabilities	600000	600000
total assets	2000000	2000000
additional cash	0	500000
total assets after	2000000	2500000
ratio	0.30	0.24
as evident from the above , debt ratio will decline

times interest earned ratio

earnings befor interest and tax / intereste expense

no change as cash or capital does not form part of the ratio

operating profit margin	(operating profit / sales)*100
no change as cash or capital does not form part of the formula

basic earnings power	EBIT / total assets
	before	after
total assets	2000000	2000000
additional cash	0	500000
total assets after	2000000	2500000
EBIT	2400000	2400000
basic earnings power	1.20	0.96
basic earnings power will decline due to increase in assets

current ratio	current assets / current liabilities
	before	after
current assets	1000000	1000000
additional cash	0	500000
total current assets	1000000	1500000
current liabilities	100000	100000
current ratio	10	15
ratio will increase due to increase current assets

Transaction 2

fixed assets turnover ratio = sales / average fixed assets

no change in this ratio due to loan taken.

debt ratio: as loan is taken assets and liabilities both will increase.

debt ratio	total liabilities / total assets
	before
total liabilites	600000
total assests	2000000
ratio	0.3
after taking loan	after
total liabilities (600000+500000)	1100000
total assets (2000000+500000)	2500000
ratio	0.44

basis on the above ratio will increase

gross profit margin = (gross profit / sales) * 100

gross profit margin there will be no changes as taking loan does not impact this ratio

operating profit margin = (operating profit / sales) * 100

no change operating margin as it does not impact any of the items used in the calculation

return on assets: as the company has taken loan - it will increase the balance of total assets. No changes will be reported in operating income

return on assets	operating income / total assets
	before	after
operating income	2400000	2400000
total assets	2000000	2000000
loan	0	500000
total assets after loan	2000000	2500000
ratio	1.2	0.96

basis on the above calculation ratio will decrease

current ratio: as the company is taken loan, it will increase the current assets but not current liabilities as the loan is taken for 10 year and treat as long term liabilitiy

current ratio	current assets / current liabilities
	before	after
current assets	1000000	1000000
loan taken		500000
total current assets after loan	1000000	1500000
current liabilties	100000	100000
ratio	10	15

basis on the above calculation current ratio will increase