Question

12. The effect of transactions on ratios Aa Aa E You've been asked to tutor Adaira, a finance student who doesn't feel comfortable about her 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 Adaira to complete. The purpose of these exercises is to help Adaira (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 Marketable securities 10,000 Wages payable Accounts receivable 470,000 Taxes payable Inventory 500,000 Notes payable Prepaid expenses 5,000 Total current liabilities Total current assets 1,000,000 Long-term debt Total liabilities Gross plant and equipment 1,500,000 Common stock Accumulated depreciation 500,000 Capital paid in excess of par Net plant and equipment 1,000,000 Retained earnings Total equity Total assets $2,000,000 Total debt and equity $20,000 20,000 10,000 50,000 100,000 500,000 600,000 150,000 350,000 900,000 1,400,000 $2,000,000 Lancashire Railway Co.'s Pretransaction Statement of Financial Performance Sales $5,000,000 Less: Cost of goods sold! 2,000,000 Gross profit 3,000,000 Less: Operating expenses 600,000 Operating profit (EBIT) 2,400,000 Less: Interest expensez 33,000 Earnings before taxes (EBT) 2,367,000 Less Tax expense 828,450 Net income $1,538,550 Cost of goods sold equals 40% of sales. Interest expense equals 6% of the combined notes payable and long-term debt balances. The average federal and state tax rate is 35%.

Answer 1

The accounts affected by sake of merchandise on credit are:

FINANCIAL ACCOUNTS:

• Retained earnings will be affected as the profit earned on the transaction will be transferred to the retained earnings.
• Sales will be increased by the amount of sales made.
• Acciunts payable will not be affected.
• Sales are made on credit hence the balance of accounts receivable will be increased.
• The balance of inventory will be reduced by the amount of sale made.
• Cash will not be affected as the sales are on credit.

FINANCIAL TRANSACTION:

• Inventory turnover ratio will be increased by the sales made on credit.
• Quick ratio will increase.
• Times interest earned ratio will have a positive impact as the increase in sales will increase the profit.
• The market to book ratio is calculated by considering the market capitalization if the entity. The market capitalization will not be affected by the sale transaction hence will not affect the ratio.
• Debt ratio will be decreased which is a positive impact as the total assets will be increased.
• Price to earnings ratio will be decreased as the earnings per share is increased.

2 Business Transaction 2: change in the inventory approach:

FINANCIAL ACCOUNTS:

• Common stock will not be affected.
• Total assets will be affected
• Accounts payable will not be affected.
• Prepaid expenses wil not be affected.
• Inventory will be reduced.

FINANCIAL TRANSACTION:

• Debt ratio will be affected as the decrease in total assets will increase the debt ratio.
• Return on assets will be affected as the total.assets change.
• Inventory turnover ratio will be increased as the inventory decrease.
• Quick ratio will be affected.
• Average collection period will be affected by the nature of sales made.
• Fixed assets turnover ratio will be affected by the sales made. It will be increased due to increase in sales.