The effect of transactions on ratios

Youve been asked to Ashley, 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 Ashley to complete. The purpose of these exercises is to help Ashley (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.

Atlanta Aeronautics 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

Atlanta Aeronautics Co.s Pretransaction Statement of Financial Performance

Sales	$5,000,000
Less: Cost of goods sold1Cost of goods sold1	2,000,000
Gross profit	$3,000,000
Less: Operating expenses	600,000
Operating profit (EBIT)	$2,400,000
Less: Interest expense2Interest expense2	33,000
Earnings before taxes (EBT)	$2,367,000
Less: Tax expense3Tax expense3	828,450
Net income	$1,538,550

11Cost of goods sold equals 40% of sales.

22Interest expense equals 6% of the combined notes payable and long-term debt balances.

33The 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

Atlanta Aeronautics Co. (AAC) 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	Check if the Account Is Affected by the Specified Transaction
Cash
Notes payable
Cost of goods sold
Retained earnings
Gross plant and equipment
Accounts payable

Financial Ratio	Ratios Behavior
Debt ratio
Quick ratio
Return on common equity
Average collection period
Fixed assets turnover

Business Transaction 2

Atlanta Aeronautics Co. (AAC) pays $10,000 of its federal and state taxes payable.

Financial Account	Check if the Account Is Affected by the Specified Transaction
Taxes payable
Long-term debt
Cash
Prepaid expenses
Net income

Financial Ratio	Ratios Behavior
Operating profit margin
Debt ratio
Quick ratio
Return on assets
Times-interest-earned