Question

Determining the effects of business transactions on selected ratios

Financial statement data of Modern Traveler’s Magazine include the following items:

Cash	\(19,000
Accounts Receivable, Net	82,000
Merchandise Inventory	183,000
Total Assets	638,000
Accounts Payable	102,000
Accrued Liabilities	35,000
Short-term Notes Payable	50,000
Long-term Liabilities	221,000
Net Income	69,000
Common Shares Outstanding	50,000 shares

Requirements

1. Compute Modern Traveler’s current ratio, debt ratio, and earnings per share. Round all ratios to two decimal places, and use the following format for your answer:

Current ratio

Debt ratio

Earnings per share

2. Compute the three ratios after evaluating the effect of each transaction that follows. Consider each transaction separately.

a. Purchased merchandise inventory of \)42,000 on account.

b. Borrowed \(121,000 on a long-term note payable.

c. Issued 5,000 shares of common stock, receiving cash of \)103,000.

d. Received cash on account, $5,000.

Short answer

1. Financial ratios

Current ratio	Debt ratio	Earnings per share
1.52 times	0.64 times	1.38 per share

2. Effect of each transaction on financial ratios:

Transaction	Current ratio	Debt Ratio	Earnings per share
a	1.42	0.66	1.38
b	1.52	0.70	1.38
c	2.07	0.55	1.25
d	1.59	0.63	1.38

Step-by-step solution

Definition of Financial Ratios

The figures that are calculated by comparing various line items of the financial statement to arrive at a conclusive decision regarding liquidity, solvency, and profitability are known as financial ratios.

Calculation of financial ratios:

Current ratio	Debt ratio	Earnings per share
$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}19,000+\mathrm{\$}82,000+\mathrm{\$}183,000}{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000}\\ =\frac{\mathrm{\$}284,000}{\mathrm{\$}187,000}\\ =1.52\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Debt}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{debt}}{\mathrm{Total}\mathrm{assets}}\\ =\frac{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000+\mathrm{\$}221,000}{\mathrm{\$}638,000}\\ =\frac{\mathrm{\$}408,000}{\mathrm{\$}638,000}\\ =0.64\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Earnings}\mathrm{per}\mathrm{share}=\frac{\mathrm{Net}\mathrm{income}}{\mathrm{Common}\mathrm{shares}\mathrm{outstanding}}\\ =\frac{\mathrm{\$}69,000}{50,000}\\ =1.38\mathrm{per}\mathrm{share}\end{array}$

Ratios after effect of transactions:

a. Purchased merchandise inventory of $42,000 on account.

Current ratio	Debt ratio	Earnings per share
$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}19,000+\mathrm{\$}82,000+\mathrm{\$}183,000+\mathrm{\$}42,000}{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000+\mathrm{\$}42,000}\\ =\frac{\mathrm{\$}326,000}{\mathrm{\$}229,000}\\ =1.42\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Debt}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{debt}}{\mathrm{Total}\mathrm{assets}}\\ =\frac{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000+\mathrm{\$}221,000+\mathrm{\$}42,000}{\mathrm{\$}638,000+\mathrm{\$}42,000}\\ =\frac{\mathrm{\$}450,000}{\mathrm{\$}680,000}\\ =0.66\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Earnings}\mathrm{per}\mathrm{share}=\frac{\mathrm{Net}\mathrm{income}}{\mathrm{Common}\mathrm{shares}\mathrm{outstanding}}\\ =\frac{\mathrm{\$}69,000}{50,000}\\ =1.38\mathrm{per}\mathrm{share}\end{array}$

b. Borrowed $121,000 on a long-term note payable.

Current ratio	Debt ratio	Earnings per share
$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}19,000+\mathrm{\$}82,000+\mathrm{\$}183,000}{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000}\\ =\frac{\mathrm{\$}284,000}{\mathrm{\$}187,000}\\ =1.52\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Debt}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{debt}}{\mathrm{Total}\mathrm{assets}}\\ =\frac{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000+\mathrm{\$}221,000+\mathrm{\$}121,000}{\mathrm{\$}638,000+\mathrm{\$}121,000}\\ =\frac{\mathrm{\$}529,000}{\mathrm{\$}759,000}\\ =0.70\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Earnings}\mathrm{per}\mathrm{share}=\frac{\mathrm{Net}\mathrm{income}}{\mathrm{Common}\mathrm{shares}\mathrm{outstanding}}\\ =\frac{\mathrm{\$}69,000}{50,000}\\ =1.38\mathrm{pershare}\end{array}$

c. Issued 5,000 shares of common stock, receiving cash of $103,000.

Current ratio	Debt ratio	Earnings per share
$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}19,000+\mathrm{\$}82,000+\mathrm{\$}183,000+\mathrm{\$}103,000}{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000}\\ =\frac{\mathrm{\$}387,000}{\mathrm{\$}187,000}\\ =2.07\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Debt}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{debt}}{\mathrm{Total}\mathrm{assets}}\\ =\frac{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000+\mathrm{\$}221,000}{\mathrm{\$}638,000+\mathrm{\$}103,000}\\ =\frac{\mathrm{\$}408,000}{\mathrm{\$}741,000}\\ =0.55\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Earnings}\mathrm{per}\mathrm{share}=\frac{\mathrm{Net}\mathrm{income}}{\mathrm{Common}\mathrm{shares}\mathrm{outstanding}}\\ =\frac{\mathrm{\$}69,000}{50,000+5,000}\\ =1.25\mathrm{pershare}\end{array}$

d. Received cash on account, $5,000.

Current ratio	Debt ratio	Earnings per share
$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}19,000+\mathrm{\$}82,000+\mathrm{\$}183,000+\mathrm{\$}5,000}{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000-\mathrm{\$}5,000}\\ =\frac{\mathrm{\$}289,000}{\mathrm{\$}182,000}\\ =1.59\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Debt}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{debt}}{\mathrm{Total}\mathrm{assets}}\\ =\frac{\mathrm{\$}102,000+\mathrm{\$}35,000+\mathrm{\$}50,000+\mathrm{\$}221,000-\mathrm{\$}5,000}{\mathrm{\$}638,000+\mathrm{\$}5,000}\\ =\frac{\mathrm{\$}403,000}{\mathrm{\$}643,000}\\ =0.63\mathrm{times}\end{array}$	$\begin{array}{c}\mathrm{Earnings}\mathrm{per}\mathrm{share}=\frac{\mathrm{Net}\mathrm{income}}{\mathrm{Common}\mathrm{shares}\mathrm{outstanding}}\\ =\frac{\mathrm{\$}69,000}{50,000}\\ =1.38\mathrm{per}\mathrm{share}\end{array}$