11. The effect of transactions on ratios

You've been asked to tutor Savannah, 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 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, 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.

Lancashire Railway Co.'s Pretransaction Statement of Financial Condition

Cash$15,000Accounts payable$20,000Marketable securities10,000Wages payable20,000Accounts receivable470,000Taxes payable10,000Inventory500,000Notes payable50,000Prepaid expenses5,000Total current liabilities100,000Total current assets1,000,000Long-term debt500,000Total liabilities600,000Gross plant and equipment1,500,000Common stock150,000Accumulated depreciation500,000Capital paid in excess of par350,000Net plant and equipment1,000,000Retained earnings900,000Total equity1,400,000Total assets$2,000,000Total debt and equity$2,000,000

Lancashire Railway Co.'s Pretransaction Statement of Financial Performance

Sales$5,000,000Less: Cost of goods sold2,000,000Gross profit3,000,000Less: Operating expenses600,000Operating profit (EBIT)2,400,000Less: Interest expense33,000Earnings before taxes (EBT)2,367,000Less: Tax expense828,450Net 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. Donotconsider 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. Ratio's 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 Ratio's Behavior

Fixed asset turnover

Debt ratio

Gross profit margin

Operating profit margin

Return on assets

Current ratio