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You’ve been asked to helpSkyla, 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 Skyla to complete. The purpose of these exercises is to help Skyla (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 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.

Wellington Industries’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

Wellington Industries’s Pretransaction Statement of Financial Performance

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

¹Cost of goods sold equals 40% of sales.

²Interest expense equals 6% of the combined notes payable and long-term debt balances.

³The 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

Wellington Industries (Wellington) 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.

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Question #1 Check all financial accounts that have been affected by the specific transaction:
A. Cash
B. Accounts payable
C. Cost of goods sold
D. Notes payable
E. Gross plant and equipment

Question #2 Select the option that best suits the following:

Financial Ratio Ratio’s Behavior
Times Interest Earned A. Increases B. Decreases C. No Change
Debt Ratio A. Increases B. Decreases C. No Change
Average Collection Period A. Increases B. Decreases C. No Change
Return on common equity A. Increases B. Decreases C. No Change
Quick Ratio A. Increases B. Decreases C. No Change
Fixed assets turnover A. Increases B. Decreases C. No Change

____________________________________________________________________________________________________________________________________________________

Business Transaction 2

Wellington Industries (Wellington) switches from holding an available inventory to a just-in-time inventory system, thereby reducing its inventory by 80.00%.

____________________________________________________________________________________________________________________________________________________

Question #3 Check all financial accounts that have been affected by the specified transaction:
A. Inventory
B. Accounts payable
C. Fixed assets turnover
D. Quick ratio
E. Return on assets
F. Debt Ratio

Question #4 Check all financial accounts that have been affected by the specific transaction:

Financial Ratio Ratio’s Behavior
Inventory A. Increases B. Decreases C. No Change
Accounts Payable A. Increases B. Decreases C. No Change
Pre-Paid Expenses A. Increases B. Decreases C. No Change
Total Assets A. Increases B. Decreases C. No Change
Common Stock A. Increases B. Decreases C. No Change

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