11. The effect of transactions on ratios

Youve been asked to teach Skyla, a finance student who doesnt feel comfortable about her understanding of the relationship between a companys business activities, its financial accounts, and the companys financial ratios. To better appreciate these relationships, youve created the following exercises for Skyla to complete. The purpose of these exercises is to help Skyla (1) understand the effect of business transactions on financial statementsuch as balance sheet and income statementaccounts and (2) how these changes in the numerators and denominators of financial ratios affect the ratios values. However, before using these exercises in your session later today, youll 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 companys financial statements and ratios, assume that the following balance sheet and income statement reflect the companys pretransaction condition and performance.

Wellington Industriess 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
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

Wellington Industriess 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 expense	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%.

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

Wellington Industries (Wellington) purchases a new piece of equipment for $50,000, using a cash down payment of $5,000 and a note payable for the outstanding balance.

Question #1 Which of these financial accounts is affected by the specified transaction? A. Cash B. Accounts payable C. Cost of goods sold D. Notes payable E. Gross plant and equipment

Question #2 What happens to the financial ratios below?

Financial Ratio	Ratio's Behavior
Times interest earned	A. Increase B. Decrease C. No Change
Debt Ratio	A. Increase B. Decrease C. No Change
Average collection period	A. Increase B. Decrease C. No Change
Return on common equity	A. Increase B. Decrease C. No Change
Quick ratio	A. Increase B. Decrease C. No Change
Fixed assets turnover	A. Increase B. Decrease C. No Change

Business Transaction 2

Wellington Industries (Wellington) switches from holding an available inventory to a just-in-time inventory system, thereby reducing its inventory by 80.00%.

Question #3 Which of these financial accounts is affected by the specified transaction? A. Inventory B. Accounts Payable C. Prepaid Expenses D. Total Assets E. Common Stock

Question #4 What happens to the financial ratios below?

Financial Ratio	Ratio's Behavior
Average Collection Period	A. Increase B. Decrease C. No Change
Inventory turnover	A. Increase B. Decrease C. No Change
Fixed assets turnover	A. Increase B. Decrease C. No Change
Quick Ratio	A. Increase B. Decrease C. No Change
Return on assets	A. Increase B. Decrease C. No Change
Debt Ratio	A. Increase B. Decrease C. No Change