11. The effect of transactions on ratios You’ve been asked to tutor Gavin, a finance student who doesn’t feel comfortable about his 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 Gavin to complete. The purpose of these exercises is to help Gavin (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 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. Wellington Industries’s Pretransaction Statement of Financial Condition Cash$15,000Accounts payable$20,000Marketable securities10,000Wages payable20,000Accounts receivable470,000Taxes payable10,000Inventory500,000Notes payable50,000Prepaid expenses5,000 Total current liabilities100,000 Total current assets1,000,000Long-term debt500,000 Total liabilities600,000Gross plant and equipment1,500,000Common stock150,000Accumulated depreciation500,000Capital paid in excess of par350,000Net plant and equipment1,000,000Retained earnings900,000 Total equity1,400,000Total assets$2,000,000Total debt and equity$2,000,000 Wellington Industries’s Pretransaction Statement of Financial Performance Sales$5,000,000Less: Cost of goods sold¹2,000,000Gross profit3,000,000Less: Operating expenses600,000Operating profit (EBIT)2,400,000Less: Interest expense²33,000Earnings before taxes (EBT)2,367,000Less: Tax expense³828,450Net 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) sells 25,000 shares of new common stock ($1 per share par value) to new and existing shareholders for $20 per share.