11. The effect of transactions on ratios

Youve been asked to teach Savannah, 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 Savannah to complete. The purpose of these exercises is to help Savannah (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 tutoring 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.

Lancashire Railway 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
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

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 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

Lancashire Railway Co. (Lancashire) 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
Common stock
Capital paid-in excess of par

Financial Ratio	Ratios Behavior
Inventory turnover
Debt ratio
Times interest earned
Operating profit margin
Basic earnings power
Current ratio

Business Transaction 2

A $500,000 10-year bank loan is initiated, and the funds are placed in Lancashire Railway Co. (Lancashire)s checking account.

Financial Account	Check if the Account Is Affected by the Specified Transaction
Long-term debt
Marketable securities
Common stock
Cash
Gross plant and equipment

Financial Ratio	Ratios Behavior
Fixed asset turnover
Debt ratio
Gross profit margin
Operating profit margin
Return on assets
Current ratio