11. The effect of transactions on ratios You've been asked to tutor Logan, 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 Logan to complete. The purpose of these exercises is to help Logan (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. Fresno Furniture Manufacturing Inc.'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 10,000 Taxes payable Notes payable Inventory 500,000 50,000 Prepaid expenses 5,000 Total current liabilities Total current assets 1,000,000 Long-term debt 100,000 500,000 600,000 150,000 Total liabilities Gross plant and equipment Common stock 1,500,000 500,000 Accumulated depreciation 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 Fresno Furniture Manufacturing Inc.'s Pretransaction Statement of Financial Performance Sales $5,000,000 2,000,000 3,000,000 Less: Cost of goods soldi Gross profit Less: Operating expenses Operating profit (EBIT) Less: Interest expense2 Earnings before taxes (EBT) Less: Tax expenses 600,000 2,400,000 33,000 2,367,000 828,450 Net income $1,538,550 1 Cost of goods sold equals 40% of sales. 2 Interest expense equals 6% of the combined notes payable and long-term debt balances. 3The 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, decrease, 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 Fresno Furniture Manufacturing Inc. (FFM) 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 Cash Operating income Long-term debt 0 0 0 0 0 Common stock Capital paid-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 Fresno Furniture Manufacturing Inc. (FFM) 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 O O O O Total assets Common stock Financial Ratio Ratio's Behavior Average collection period Inventory turnover Fixed assets turnover Quick ratio Return on assets Debt ratio
