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

Phoenix Golf Club 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

Phoenix Golf Club 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

Phoenix Golf Club Co. (PGC) 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

Accounts payable

Cost of goods sold

Notes payable

Gross plant and equipment

Financial Ratio

Ratios Behavior

Times interest earned Increased / Decreases / No change

Debt ratio

Increased / Decreases / No change

Average collection period

Increased / Decreases / No change

Return on common equity

Increased / Decreases / No change

Quick ratio

Increased / Decreases / No change

Fixed assets turnover

Increased / Decreases / No change

Business Transaction 2

Phoenix Golf Club Co. (PGC) 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

Prepaid expenses

Cash

Net income

Financial Ratio

Ratios Behavior

Average collection period

Increased / Decreases / No change

Debt ratio

Increased / Decreases / No change

Times interest earned

Increased / Decreases / No change

Operating profit margin

Increased / Decreases / No change

Return on assets

Increased / Decreases / No change

Quick ratio

Increased / Decreases / No change