11. The effect of transactions on ratios

Youve been asked to help Hubert, a finance student who doesnt feel comfortable about his 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 Hubert to complete.

The purpose of these exercises is to help Hubert (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 helping 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 pre-transaction condition and performance.

Wellington Industries
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 Industries
Statement of Financial Performance
Sales	$5,000,000
Less: Cost of goods sold (see Note 1 below)	2,000,000
Gross profit	3,000,000
Less: Operating expenses	600,000
EBIT	2,400,000
Less: Interest expense (see Note 2 below)	33,000
Earnings before taxes	2,367,000
Less: Tax expense (see Note 3 below)	828,450
Net income	$1,538,550

Notes: (1) Cost of goods sold equals 40% of sales. (2) Interest expense equals 6% of the combined notes payable and long-term debt balances. (3) 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.)

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.

Financial Account	Affected by Transaction?
Cost of goods sold	...............(yes or no)
Gross plant and equipment	..............(yes or no)
Retained earnings	..............(yes or no)
Cash	.............(yes or no)
Notes payable	.............(yes or no)
Accounts payable	.............(yes or no)

Financial Ratio	Ratios Behavior
Quick ratio	..............(increase or no change or decrease)
Debt ratio	............(increase or no change or decrease)
Average collection period	............(increase or no change or decrease)
Fixed assets turnover	............(increase or no change or decrease)
Return on common equity	............(increase or no change or decrease)
Times interest earned	............(increase or no change or decrease)

Business Transaction 2: Wellington Industries (Wellington) labor force goes on strike for two months, reducing company sales by 20%

Financial Account	Affected by Transaction?
Notes Payable	(yes or no)...............
Tax Expense	(yes or no)
Inventory...........	(yes or no)
Sales.......	(yes or no)
Common Stock .......(yes or no)

Financial Ratio	Ratios Behavior
Average collection period	...........(increase or no change or decrease)
basic earning power	............(increase or no change or decrease)
Inventory turnover	...........(increase or no change or decrease)
current ratio	...........(increase or no change or decrease)
debt ratio	............(increase or no change or decrease)
operating profict margin	...........(increase or no change or decrease)