11. The effect of transactions on ratios You've been asked to tutor Caleb, 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 Caleb to complete. The purpose of these exercises is to help Caleb (1) understand the effect of business transactions on financial statement-such as balance sheet and income statement-occounts and (2) how these changes in the numerators and denominators of financial ratios affect the ratlos 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. Atlanta Aeronautics Co.'s Pretransaction Statement of Financial Condition Cash $15,000 Accounts payable $20,000 Marketable securities 10,000 Wages payable 20,000 Accounts receivable 470,000 Taxes payable 10,000 Inventory 500,000 Notes payable 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 Grous 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 Atlanta Aeronautics Co.'s Pretransaction Statement of Financial Performance Sales Less: Cost of goods sold! Gross profit $5,000,000 2,000,000 3,000,000 Atlanta Aeronautics Co.'s Pretransaction Statement of Financial Performance Sales Less: Cost of goods sold Gross profit Less: Operating expenses Operating profit (EBIT) Less: Interest expense Earings before taxes (EBT) Less: Tox expense $5,000,000 2,000,000 3,000,000 600,000 2,400,000 33,000 2,367,000 828,450 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%. Indicate If any of the listed financial statement accounts is affected by the following business transactions and whether the listed ratios will increase, decrense, or remain unchanged as a result of the transaction. (Hint: Assume that the business transaction occurs exactly as stated without interpreting it further. Do not consider any related transactions that may occur before or after the specified transaction. Assume there are 365 days in a year) Business Transaction 1 Atlanta Aeronautics Co. (AAC) sells 25,000 shares of new common stock ($1 per share par value) to new and existing shareholders for $20 per share Financial Account Check if the Account Is Affected by the Specified Transaction fo MSS Mdlysis Ul Find Financial Account Check if the Account Is Affected by the Specified Transaction Cash B Operating Income D Long-term debt Common stock Capital pald-in excess of par Financial Ratio Ratio's Behavior Inventory turnover Debt ratio Times Interest earned Operating profit margin Basic earnings power current ratio Business Transaction 2 Atlanta Aeronautics Co. (AAC) switches from holding an available inventory to a just-in-time Inventory system, thereby reducing its inventory by 80.00%. Financial Account Check if the Account Is Affected by the Specified Transaction Inventory Accounts payable Prepald expenses Total assets Basic earnings power Current ratio Business Transaction 2 Atlanta Aeronautics Co. (AAC) switches from holding an available inventory to a just-in-time inventory system, thereby reducing its inventory by 80.00%. Financial Account Check if the Account Is Affected by the Specified Transaction Inventory Accounts payable Prepaid expenses Total assets Common stock Ratio's Behavior Financial Ratio Average collection period Inventory turnover Fixed assets turnover Quick ratio Return on assets Debt ratio