12. The effect of transactions on ratios You've been asked to tutor Adaira, a finance student who doesn't feel comfortable about her 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 Adaira to complete. The purpose of these exercises is to help Adaira (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. Edinburgh Exports Inc.'s Pretransaction Statement of Financial Condition Cash $15,000 Accounts payable Marketable securities 10,000 Wages payable Accounts receivable 470,000 Taxes payable Inventory 500,000 Notes payable Prepaid expenses 5,000 Total current liabilities Total current assets 1,000,000 Long-term debt Total liabilities Gross plant and equipment 1,500,000 Common stock Accumulated depreciation 500,000 Capital paid in excess of par Net plant and equipment 1,000,000 Retained earnings Total equity Total assets $2,000,000 Total debt and equity $20,000 20,000 10,000 50,000 100,000 500,000 600,000 150,000 350,000 900,000 1,400,000 $2,000,000 Edinburgh Exports Inc.'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 expenses 828,450 Net income $1,538,550 1Cost of goods sold equals 40% of sales. 2 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.) Business Transaction 1 Business Transaction 1 Edinburgh Exports Inc. (EEI) sells $165,000 of merchandise on credit Ratio's Behavior Check if the Account Is Affected by the Specified Transaction Financial Account Accounts payable Accounts receivable Retained earnings Inventory Sales Cash Financial Ratio Times interest earned Market-to-book ratio Inventory turnover ratio Debt ratio Quick ratio Price-to-earnings ratio Business Transaction 2 A $500,000 10-year bank loan is initiated, and the funds are placed in Edinburgh Exports Inc. (EEI)'s checking account. Check if the Account Is Affected by the Specified Transaction Ratio's Behavior Financial Account Marketable securities Common stock Gross plant and equipment Long-term debt Cash Financial Ratio Debt ratio Operating profit margin Times interest earned Fixed asset turnover Return on assets Gross profit margin Flash Fayer MAC 32,0,0,371
