PROBLEM 15–13 Effects of Transactions on Various Financial Ratios LO15–2, LO15–3,

LO15–4, LO15–5, LO15–6

In the right-hand column below, certain financial ratios are listed. To the left of each ratio is a
business transaction or event relating to the operating activities of Delta Company (each
transaction should be considered independently).
Page 753 on the book, Page 786 on the pdf

Required:
Indicate the effect that each business transaction or event would have on the ratio listed
opposite to it. State the effect in terms of increase, decrease, or no effect on the ratio involved,
and give the reason for your answer. In all cases, assume that the current assets exceed the
current liabilities both before and after the event or transaction. Use the following format for your
answers:

Effect on Ratio Reason for Increase, Decrease, or No Effect

1. Decrease When a corporation's board of directors declares a cash

dividend on its stock, the following will occur: Retained
earnings (a part of stockholders' equity) will decrease.
Current assets will not be affected while current liabilities
(such as Dividends Payable) will increase, therefore
 current ratio will decrease. However, when the dividend is
paid, current assets and current liabilities will both
decrease.

2. Increases Inventory isn’t necessarily part of the acid-test ratio

(Cash/Cash Equivalents + Accounts Receivable / Current
Liabilities), since it isn’t an asset that can be quickly
converted into cash. And while there will be no change in
current liabilities, quick assets will increase as accounts
receivable increases as well. As a result, the acid-test ratio
will increase.

3. Increase Net income will increase by 10% of the value of the bonds
issued and decrease by 8% because of the interest
expense, so it will increase by 2% net. Return on equity is
net income ÷ stockholders' equity, so an increase in net
income leads to an increase in the ratio

4. Decrease The accounts needed to compute for the times interest

earned ratio are the earnings before interest and tax, and
the interest expense. The ratio will decrease because in
the instance of the net income income decreases while the
long term debt has not changed, this means that the EBIT
has decreased.

5. Increase Payment of a previously declared cash dividend will reduce

both current assets and current liabilities by the
same amount. An equal reduction in both current assets
and current liabilities will always result in an increase in the
current ratio, so long as the current assets exceed the
current liabilities.

6. No Effect The dividend payout ratio is the dividends per share ÷

earnings per share. The market price is not an element of
the ratio.

7. Obsolete inventory The write-off decreases the Cost of Goods Sold expense
totaling 100,000 was with the loss and decreases the average inventory by 50%
written off as loss of the amount. This leads to an increase in the ratio.

Increase A write-off of inventory will reduce the inventory balance,

thereby increasing the turnover in relation to a given level
of sales.

8. Sold inventory for cash at According to the transaction, the shareholders’ equity
a profit increases due to the retained earnings from the sold
inventory. This means that the total liabilities have less
Decrease weight compared to equity.
9. Increase There would be an increase in the accounts receivable
turnover ratio because of the new terms, in compliance
with the industries practices. The change in the turnover
terms would make the customers pay their accounts
sooner, thus, increase the turnover ratio.

10. Decrease Book value per share is computed by the total stockholders
equity divided by the number of common shares
outstanding. The common stock dividend reduces the
market value per share of the company’s stock. It results in
a greater number of shares outstanding without any
change in its assets.

11. No effect Book value per share is not affected by the current market
prices of the company’s common stock. It is only used to
compare between the two for the investor to see if he/she
can buy the common stock at market value based on the
BVPS. If BVPS is higher than the market value, then the
investor can buy the stock at a lesser price than its actual
value; it also applies vice versa.

12. No effect Working capital = current assets - current liabilities. The

transactions decrease cash and Accounts Payable by the
same amount, and this means working capital stays the
same.

Decreasing the company’s accounts payable will not

change the amount of the company’s working capital
considering that what companies use to pay liabilities are
just coming from the assets or the capital being invested to
the business.

13. No effect Dividends on common stock do not impact the EPS

calculation. Stock dividends have no effect on the total
amount of stockholders' equity or on net assets. They
merely decrease retained earnings and increase paid-in
capital by an equal amount. Immediately after the
distribution of a stock dividend, each share of similar stock
has a lower book value per share.

Even if the dividend is issued as additional shares of stock,

the value of that stock is deducted; however, a cash
dividend results in a straight reduction of retained earnings,
while a stock dividend results in a transfer of funds from
retained earnings to paid-in capital.

Earnings per share - net income ÷ Weighted average

shares outstanding. A stock dividend does not affect the
weighted average shares outstanding.
14. Decrease One of the most frequent approaches to reduce one's D/E
ratio, assuming the company doesn't request any new
loans, is to pay off debts. By doing this, the equity remains
constant while reducing the total assets and total liabilities
by the same, balancing amount. Accordingly, a lower total
liabilities value divided by the same total equity value would
produce a lower quotient — a lower D/E ratio.

15. Decrease A purchase of inventory on account means that current

liabilities would be increased and inventory would increase
as well. But since this is a quick or acid test ratio, it will
decrease since inventories are deducted from current
assets for this ratio while the accounts payable in the
current liabilities remain. Therefore, only current liabilities
are affected in this problem which then decreases the acid
test ratio.

16. No effect A write off in an uncollectible account against the

Allowance for Bad Debts means that there will be a
decrease in accounts receivable and the allowance for bad
debts. There will be no effect since allowance for bad debts
offsets the accounts receivable account this means that
even if there was no write off, both accounts equate to 0
which doesn’t affect current assets. This will then not affect
the total current assets and consecutively, would not affect
the current ratio.

17. Increase In the formula

𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑝𝑟𝑖𝑐𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜 = 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
,

market price per share has a direct relationship with

price-earnings ratio. To illustrate:
24.50
𝑝𝑟𝑖𝑐𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜 = 1
= 24. 50
30
𝑝𝑟𝑖𝑐𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜 = 1
= 30

The market price per share and price-earnings (P/E) ratio

have a direct relationship because the P/E ratio is
calculated by dividing the market price per share by the
earnings per share. Therefore, as the market price per
share increases, the P/E ratio also increases, assuming
earnings remain constant.
18. Decrease In the formula

𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
,

market price per share has an inverse relationship with

dividend yield ratio. To illustrate:
1
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 𝑟𝑎𝑡𝑖𝑜 = 24.50 = 0. 04
1
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 𝑟𝑎𝑡𝑖𝑜 = 30
= 0. 03

The market price per share and dividend yield ratio have
an inverse relationship because as the market price per
share increases, the dividend yield ratio decreases, and
vice versa. This is because the dividend yield ratio is
calculated by dividing the annual dividend per share by the
market price per share. Therefore, if the market price per
share increases, the dividend yield ratio decreases, as the
dividend per share remains constant.