ANALYZING AND RECORDING TRANSACTIONS

Chapter 2

2009 The McGraw-Hill Companies, Inc., All Rights Reserved

C1

ANALYZING AND RECORDING PROCESS

Analyze each transaction and event from source documents

Record relevant transactions and events in a journal

Prepare and analyze the trial balance

McGraw-Hill/Irwin

Post journal information to ledger accounts

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SOURCE DOCUMENTS
Checks Employee Earnings Records Bills from Suppliers Purchase Orders

Bank Statements Sales Tickets

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THE ACCOUNT AND ITS ANALYSIS

An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item.
What's an "Account"?
McGraw-Hill/Irwin
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The general ledger is a record containing all accounts used by the company.

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THE ACCOUNT AND ITS ANALYSIS

Assets Assets Asset Accounts Accounts Accounts

Liability Liability Liability Accounts Accounts Accounts

Equity Equity Equity Accounts Accounts Accounts

Owner, Capital Owner, Withdrawals

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ASSET ACCOUNTS
Cash Accounts Receivable

Land

Buildings

Asset Accounts
Supplies

Notes Receivable

Equipment

Prepaid Accounts

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LIABILITY ACCOUNTS
Accounts Payable Notes Payable

Liability Accounts
Accrued Liabilities
McGraw-Hill/Irwin

Unearned Revenue
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EQUITY ACCOUNTS
Owners Equity

Owners Withdrawals

Equity Accounts
Revenues Expenses Owners Capital
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McGraw-Hill/Irwin

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THE ACCOUNT AND ITS ANALYSIS

Assets

Liabilities

+
+

Equity

+
Owners Capital

Owner's Withdrawals

Expenses

Revenues

McGraw-Hill/Irwin

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C4

LEDGER AND CHART OF ACCOUNTS

Explanation of Chart of Accounts

The ledger is a collection of all accounts for an information system. A companys size and diversity of operations affect the number of accounts needed.
The chart of accounts is a list of all accounts and includes an identifying number for each account.
Account Number 101 106 126 128 167 201 236 301
McGraw-Hill/Irwin

Account Name Cash Accounts receivable Supplies Prepaid insurance Equipment Accounting payable Unearned revenue C. Taylor, Capital

Accounting Number 302 403 406 622 637 640 652 690

Accounting Name C. Taylor, Withdrawals Revenues Rental revenue Salaries expense Insurance expense Rent expense Supplies expense Utilities expense
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C5

DEBITS AND CREDITS

A T-account represents a ledger account and is a tool used to understand the effects of one or more transactions.
Account Title (Left side) (Right side) Debit Credit Dr. Cr.

Debits & Credits

McGraw-Hill/Irwin

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Double Entry System

Double Entry System

Double entry is a simple yet powerful concept: each and every one of a company's transactions will result in an amount recorded into at least two of the accounts in the accounting system. Double-entry bookkeeping system was first codified in the 15th century by Luca Pacioli. In deciding which account has to be debited and which account has to be credited, the golden rules of accounting are used. In modern accounting this is done using debits and credits within the accounting equation: Equity = Assets - Liabilities. The accounting equation serves as an error detection tool. If at any point the sum of debits does not equal the corresponding sum of credits, an error has occurred. It follows that the sum of debits and the sum of the credits must be equal in value.
McGraw-Hill/Irwin
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DOUBLE-ENTRY ACCOUNTING

Assets
ASSETS

Liabilities
LIABILITIES

Equity
EQUITIES

Debit

Credit

Debit

Credit

Debit

Credit

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DOUBLE-ENTRY ACCOUNTING

Equity
Owners Capital
Owners Capital

Owner's Withdrawals
Owner's Withdrawals

Revenues
Revenues

_ Expenses
Expenses

Debit Credit

Debit Credit

Debit Credit

Debit Credit

McGraw-Hill/Irwin

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(Accounting Equation)
=+ ()+
- -+-

=+-+-+- +++=+++
(debit)

(credit)

McGraw-Hill/Irwin

Normal Balances

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QUICK STUDY
QS 2-3 Identify the normal balance (debit or credit) for each of the following accounts. a. Office supplies b. Owner Withdrawals c. Fees Earned d. Wages Expense e. Cash f. Prepaid Insurance g. Wages Payable h. Building i. Owner Capital

debit
debit credit debit debit debit credit

debit
credit

McGraw-Hill/Irwin

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QUICK STUDY
QS 2-4 Indicate whether a debit or credit decreases the normal balance of each of the following accounts.
debit debit credit credit

debit
credit credit debit credit debit debit credit

a. Repair Services Revenue b. Interest Payable c. Accounts Receivable d. Salaries Expense e. Owner Capital f. Prepaid Insurance g. Buildings h. Interest Revenue i. Owner Withdrawals j. Unearned Revenue k. Accounts Payable l. Office Supplies
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McGraw-Hill/Irwin

QUICK STUDY
QS 2-5 Identify whether a debit or credit yields the indicated change for each of the following accounts. a. To increase Land b. To decrease Cash c. To increase Utilities Expense d. To increase Fees Earned e. To decrease Unearned Revenue f. To decrease Prepaid Insurance g. To increase Notes Payable h. To decrease Accounts Receivable i. To increase Owner Capital j. To increase Store Equipment
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debit credit debit credit debit credit credit credit credit debit

McGraw-Hill/Irwin

Multiple Choice Quiz

b

1. Amalia Company received its utility bill for the current period of $700 and immediately paid it. Its journal entry to record this transaction includes a a. Credit to Utility Expense for $700. Utility Expense 700 Cash 700 b. Debit to Utility Expense for $700. c. Debit to Accounts Payable for $700. d. Debit to Cash for $700. e. Credit to capital for $700. 2. On May 1, Mattingly Lawn Service collected $2,500 cash from a customer in advance of five months of lawn service. Mattinglys journal entry to record this transaction includes a a. Credit to Unearned Lawn Service Fees for $2,500. b. Debit to Lawn Service Fees Earned for $2,500. c. Credit to Cash for $2,500. d. Debit to Unearned Lawn Service Fees for $2,500. e. Credit to capital for $2,500. Cash 2,500
Unearned Lawn Service Fees 2,500
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McGraw-Hill/Irwin

C5

DOUBLE-ENTRY ACCOUNTING
An account balance is the difference between the increases and decreases in an account. Notice the T-Account.

Cash
Investment by owner Consulting services revenues earned Collection of accounts receivable 30,000 Purchase of supplies 4,200 Purchase of equipment 1,900 Payment of rent Payment of salary Payment of account payable Withdrawal by owner 36,100 Total decreases 4,800 2,500 26,000 1,000 700 900 200 31,300

Total increases Balance

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JOURNALIZING & POSTING TRANSACTIONS

Assets

Liabilities

Equity

T- Account (Left side) (Right side) Debit Credit

Step 1: Analyze transactions and source documents.

Step 2: Apply doubleentry accounting

ACCOUNT NAME:
Date Description PR

ACCOUNT No.
Debit Credit Balance

GENERAL JOURNAL
Date Description Post. Ref.

Page
Debit

123
Credit

Step 4: Post entry to ledger

McGraw-Hill/Irwin

Step 3: Record journal entry

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JOURNALIZING TRANSACTIONS
Transaction Date Titles of Affected Accounts

GENERAL JOURNAL
Date 2009 Dec. 1 Cash Description PR Debit 30,000 C. Taylor, Capital Investment by owner
Transaction Dec. 2 Supplies explanation Cash
McGraw-Hill/Irwin

Page 1
Credit

30,000

Dollar amount2,500 of debits and credits

2,500
Slide 22

Multiple Choice Quiz(p.73)

c

3. Liang Shue contributed $250,000 cash and land worth $500,000 to open his new business, Shue Consulting. Which of the following journal entries does Shue Consulting make to record this transaction? a. Cash Assets . . . . . . . . . . 750,000 L. Shue, Capital . . . . . 750,000 b. L. Shue, Capital . . . . . . . 750,000 Assets . . . . . . . . . . . . . 750,000 c. Cash . . . . . . . . . . . . . . . 250,000 Land . . . . . .. . . . . . . . . . 500,000 L. Shue, Capital . . . . . 750,000 d. L. Shue, Capital . . . 750,000 Cash . . . . . . . . . . . . . . 250,000 Land . . . . . . . . . . . . . . 500,000
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McGraw-Hill/Irwin

QUICK STUDY
QS 2-6(p.74) Prepare journal entries for each of the following selected transactions. a. On January 13, DeShawn Tyler opens a landscaping company called Elegant Lawns by investing $80,000 cash along with equipment having a $30,000 value. b. On January 21, Elegant Lawns purchases office supplies on credit for $820. c. On January 29, Elegant Lawns receives $8,700 cash for performing landscaping services. d. On January 30, Elegant Lawns receives $4,000 cash in advance of providing landscaping services to a customer. Jan. 13 Cash 80,000 Equipment 30,000 D. Tyler, Capital 110,000
Owner invests cash and equipment.

21

Office Supplies Accounts Payable

Purchased office supplies on credit.

820 820

29
30

Cash Landscaping Services Revenue

Received cash for landscaping services.

8,700
8,700 4,000
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Cash 4,000 Unearned Landscaping Services Revenue

Received cash in advance for landscaping services.

McGraw-Hill/Irwin

P1

BALANCE COLUMN ACCOUNT

T-accounts are useful illustrations, but balance column ledger accounts are used in practice.
CASH
Date 2009 Dec. 1 Dec. 2 Dec. 3 Dec. 10 Description PR

ACCOUNT No. 101

Debit Credit Balance

Initial investment Purchased supplies Purchased equipment Collection from customer

30,000 2,500 26,000 4,200

30,000 27,500 1,500 5,700

McGraw-Hill/Irwin

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POSTING JOURNAL ENTRIES

GENERAL JOURNAL
Date 2009 Dec. 1 Cash Description PR Debit 30,000 C. Taylor, Capital Investment by owner 30,000

Page 1
Credit

Identify the debit account in ledger.

ACCOUNT No.
Description PR Debit Credit

CASH
Date 2009

101
Balance

McGraw-Hill/Irwin

Dec. 3

Purchased equipment

G1

20,000.00

Slide 26 ########

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POSTING JOURNAL ENTRIES

GENERAL JOURNAL
Date 2009 Dec. 1 Cash Description PR Debit 30,000 C. Taylor, Capital Investment by owner 30,000

Page 1
Credit

Enter the date.

ACCOUNT No.
Description PR Debit Credit

CASH
Date 2009 Dec. 1
McGraw-Hill/Irwin

101
Balance

Dec. 3

Purchased equipment

G1

20,000.00

########

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POSTING JOURNAL ENTRIES

GENERAL JOURNAL
Date 2009 Dec. 1 Cash Description PR Debit 30,000 C. Taylor, Capital Investment by owner 30,000

Page 1
Credit

Enter the amount and description.

ACCOUNT No.
Description PR Debit Credit

CASH
Date 2009 Dec. 1
McGraw-Hill/Irwin

101
Balance

Investment by owner Purchased equipment

G1

30,000 20,000
Slide 28 (20,000)

Dec. 3

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POSTING JOURNAL ENTRIES

GENERAL JOURNAL
Date 2009 Dec. 1 Cash Description PR Debit 30,000 C. Taylor, Capital Investment by owner 30,000

Page 1
Credit

Enter the journal reference.

ACCOUNT No.
Description PR G1 G1 Debit Credit

CASH
Date 2009 Dec. 1
McGraw-Hill/Irwin

101
Balance

Investment by owner Purchased equipment

30,000 20,000
Slide (20,000)29

Dec. 3

P1

POSTING JOURNAL ENTRIES

GENERAL JOURNAL
Date 2009 Dec. 1 Cash Description PR Debit 30,000 C. Taylor, Capital Investment by owner 30,000

Page 1
Credit

Compute the balance.

ACCOUNT No.
Description PR G1 G1 Debit Credit

CASH
Date 2009 Dec. 1
McGraw-Hill/Irwin

101
Balance

Investment by owner Purchased equipment

30,000 20,000

30,000 (20,000)
Slide 30

Dec. 3

P1

POSTING JOURNAL ENTRIES

GENERAL JOURNAL
Date 2009 Dec. 1 Cash Description PR 101 C. Taylor, Capital Investment by owner Debit 30,000 30,000

Page 1
Credit

Enter the ledger reference.

ACCOUNT No.
Description PR G1 G1 Debit Credit

CASH
Date 2009 Dec. 1
McGraw-Hill/Irwin

101
Balance

Investment by owner Purchased equipment

30,000 20,000

30,000
Slide 31 (20,000)

Dec. 3

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A1

ANALYZING TRANSACTIONS
Transaction: Owner invested $30,000 in FastForward on Dec. 1.
Analysis:
Assets Cash 30,000 = Liabilities + Equity Capital 30,000

Double entry:
(1) Cash C. Taylor, Capital 101 301
101

30,000 30,000
301 301 30,000

Posting:
(1) Cash 30,000

C. Taylor, Capital (1)

McGraw-Hill/Irwin

Slide 43

A1

ANALYZING TRANSACTIONS
Transaction: FastForward purchases supplies by paying $2,500 cash.

Analysis:
Cash (2,500) Assets Supplies 2,500 = Liabilities + Equity Capital

Double entry:
(2) Supplies Cash 126 101 2,500 2,500

Posting:
(2) Supplies 2,500
126

(1)

Cash 30,000

101

(2)

2,500

McGraw-Hill/Irwin

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A1

ANALYZING TRANSACTIONS
Transaction: FastForward purchases equipment by paying $26,000 cash.

Analysis:
Assets Cash Equipment (26,000) 26,000 = Liabilities + Equity Capital

Double entry:
(3) Equipment Cash 167 101 26,000 26,000

Posting:
(3) Equipment 26,000
167

(1)

Cash 30,000

101

(2) (3)

2,500 26,000
Slide 45

McGraw-Hill/Irwin

A1

ANALYZING TRANSACTIONS
Transaction: FastForward purchases $7,100 of supplies on credit.
Analysis:
Assets Supplies 7,100 = Liabilities Accounts Payable 7,100 + Equity Capital

Double entry:
(4) Supplies Accounts payable 126 201 7,100 7,100

Posting:
(2) (4)
McGraw-Hill/Irwin

Supplies 2,500 7,100

126

Accounts Payable (4)

201

7,100

Slide 46

A1

ANALYZING TRANSACTIONS
Transaction: FastForward provides consulting services and immediately collects $4,200 cash.

Analysis:
Assets Cash 4,200 = Liabilities + Equity Revenue 4,200

Double entry:
(5) Cash Consulting Revenue 101 403 4,200 4,200

Posting:
(1) (5)
McGraw-Hill/Irwin

Cash 30,000 4,200

403

(2) (3)

2,500 26,000

101 Consulting Revenue (5) 4,200

Slide 47

Accounting Equation for a Sole Proprietorship: Transactions 18

Accounting Equation for a Corporation: Transactions C1C8

McGraw-Hill/Irwin
Slide 48

EXERCISES
Exercise 2-2(p.75) Use the information in each of the following separate cases to calculate the unknown amount. cash a. During October, Alcorn Company had $104,750 of 9/30 ? cash receipts and $101,607 of cash disbursements. 9/30 13,926 The October 31 Cash balance was $17,069. 104,750 101,607 Determine how much cash the company had at the 10/31 17,069 close of business on September 30. b. On September 30, Mordish Co. had a $83,250 Accounts Receivable balance in Accounts Receivable. During October, the company collected $75,924 from its credit customers. 9/30 83,250 The October 31 balance in Accounts Receivable was 75,924 ?=78,504 ? $85,830. Determine the amount of sales on account 10/31 85,830 that occurred in October. c. Strong Co. had $148,000 of accounts payable on Accounts Payable September 30 and $137,492 on October 31. Total 9/30 148,000 purchases on account during October were $271,876. ?=282,384 ? 271,876 Determine how much cash was paid on accounts payable during October. 10/31 137,492
McGraw-Hill/Irwin
Slide 49

EXERCISES
Exercise 2-3(p.75) Nology Co. bills a client $65,000 for services provided and agrees to accept the following three items in full payment: (1) $12,000 cash, (2) computer equipment worth $90,000, and (3) to assume responsibility for a $37,000 note payable related to the computer equipment. The entry Nology makes to record this transaction includes which one or more of the following? a. $37,000 increase in a liability account d. $65,000 increase in an asset account b. $12,000 increase in the Cash account e. $65,000 increase in a revenue account c. $12,000 increase in a revenue account f. $37,000 increase in an equity account
Cash Computer Equipment Note Payable Services Revenue 12,000 90,000 37,000 65,000

Accepted cash, equipment and note for services.

a. b. e.

$37,000 increase in a liability account. $12,000 increase in the Cash account. $65,000 increase in a revenue account.

McGraw-Hill/Irwin

Slide 50

P2

After processing its remaining transactions for December, Fast Forwards Trial Balance is prepared.
Fast Forward Trial Balance December 31, 2009 Cash Accounts receivable Supplies Prepaid Insurance Equipment Accounts payable Unearned consulting revenue C. Taylor, Capital Owner's Withdrawals Consulting revenue Rental revenue Salaries expense Rent expense Utilities expense Total Debits $ 4,350 9,720 2,400 26,000 Credits

6,200 3,000 30,000 5,800 300

The trial balance lists all account balances in the general ledger. If the books are in balance, the total debits will equal the total credits.

200

1,400 1,000 230 $ 45,300 $ 45,300

Slide 51

McGraw-Hill/Irwin

P2

PREPARING A TRIAL BALANCE

Preparing a trail balance involves three steps: 1.List each account title and its amount (from ledger) in the trial balance. If an account has a zero balance, list it with a zero in the normal balance column (or omit it entirely). 2.Compute the total of debit balances and the total of credit balances. 3.Verify (prove) total debit balances equal total credit balances.

McGraw-Hill/Irwin

Slide 52

P2

SEARCHING FOR AND CORRECTING ERRORS

If the trial balance does not balance, the error(s) must be found and corrected.

Make sure the trial balance columns are correctly added. Make sure account balances are correctly entered from the ledger. See if debit or credit accounts are mistakenly placed on the trial balance.
McGraw-Hill/Irwin

Re-compute each account balance in the ledger. Verify that each journal entry is posted correctly. Verify that each original journal entry has equal debits and credits.
Slide 53

Multiple Choice Quiz(p.73)

d 4. A trial balance prepared at year-end shows total credits exceed total debits by $765. This discrepancy could have been caused by a. An error in the general journal where a $765 increase in Accounts Payable was recorded as a $765 decrease in Accounts Payable. b. The ledger balance for Accounts Payable of $7,650 being entered in the trial balance as $765. c. A general journal error where a $765 increase in Accounts Receivable was recorded as a $765 increase in Cash. d. The ledger balance of $850 in Accounts Receivable was entered in the trial balance as $85. e. An error in recording a $765 increase in Cash as a credit.

debit

credit
exceed 765 765

a
b c d e

765 exceed 1,530 exceed 6,885

7,650 765

A/R 765 Cash 765

850 85 exceed 765 765 765 exceed 1,530
Slide 54

McGraw-Hill/Irwin

QUICK STUDY(p.74)
QS 2-7 A trial balance has total debits of $20,000 and total credits of $24,500. Which one of the following errors would create this imbalance? Explain. a. A $2,250 credit to Consulting Fees Earned in a journal entry is incorrectly posted to the ledger as a $2,250 debit, leaving the Consulting Fees Earned account with a $6,300 credit balance. b. A $4,500 debit to Salaries Expense in a journal entry is incorrectly posted to the ledger as a $4,500 credit, leaving the Salaries Expense account with a $750 debit balance. c. A $2,250 debit to Rent Expense in a journal entry is incorrectly posted to the ledger as a $2,250 credit, leaving the Rent Expense account with a $3,000 debit balance. d. A $2,250 debit posting to Accounts Receivable was posted mistakenly to Cash. e. A $4,500 debit posting to Equipment was posted mistakenly to Supplies. f. An entry debiting Cash and crediting Notes Payable for $4,500 was mistakenly not posted.
McGraw-Hill/Irwin

Debit 20,000

Credit 24,500
exceed 4,500 2,250

a b

2,250 exceed 4,500 4,500

4,500 exceed 9,000 2,250

c
d e f

2,250 exceed 4,500

A/R 2,250 Cash 2,250 Equipment 2,250 Supplies 2,250 4,500 0 4,500 0

The correct answer is c.

Slide 55

P3

USING A TRIAL BALANCE TO PREPARE FINANCIAL STATEMENTS

Point in Time Period of Time
Statement of Cash Flows

Point in Time

Statement of Owners Equity

Income Statement

Beginning Balance Sheet

Ending Balance Sheet

McGraw-Hill/Irwin

Slide 56

QUICK STUDY
QS 2-2 2-2(p.74) Identify the financial statement(s) where each of the following items appears. Use I for income statement, E for statement of owners equity, and B for balance sheet. a. Service fees earned b. Cash withdrawal by owner c. Office equipment d. Accounts payable e. Cash f. Utilities expenses g. Office supplies h. Prepaid rent i. Unearned fees
Slide 57

I E B B B

I
I B B

McGraw-Hill/Irwin

P3

INCOME STATEMENT
FASTFORWARD Income Statement For the Month Ended December 31, 2009 Revenues: Consulting revenue $ 5,800 Rental revenue 300 Total revenues $ 6,100 Expenses: Rent expense 1,000 Salaries expense 1,400 Utilities expense 230 Total expenses 2,630 Net income $ 3,470

McGraw-Hill/Irwin

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P3

STATEMENT OF OWNER'S EQUITY

Connections
FASTFORWARD Income Statement For the Month Ended December 31, 2009 Revenues: Consulting revenue $ 5,800 Rental revenue 300 Total revenues $ 6,100 Expenses: Rent expense 1,000 Salaries expense 1,400 Utilities expense 230 Total expenses 2,630 Net income $ 3,470
McGraw-Hill/Irwin

FASTFORWARD Statement of Owner's Equity For the Month Ended December 31, 2009 C. Taylor, Capital 12/1/09 Net income for December Plus: Investments by Owner
$

3,470 30,000 33,470

Less: Owner Withdrawals C. Taylor, Capital, 12/31/09

$

200 33,270

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P3

BALANCE SHEET
Statement of Owner's Equity

For the Month Ended December 31, 2009

C. Taylor, Capital 12/1/09 Net income for December Plus: Investments by Owner

3,470 30,000 33,470

Less: Owner Withdrawals . C. Taylor, Capital, 12/31/09 $

200 33,270

Connections

Cash Supplies Prepaid insurance Equipment Total assets Liabilities Accounts payable Unearned revenue Total liabilities Equity

FASTFORWARD Balance Sheet December 31, 2009 Assets $

$ $

4,350 9,720 2,400 26,000 42,470 6,200 3,000 9,200

C. Taylor, Capital Total equity Total liabilities and equity

McGraw-Hill/Irwin

$ $

33,270 33,270 42,470

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P3

PRESENTATION ISSUES

1. Dollar signs are not used in journals and ledgers. 2. Dollar signs appear in financial statements and other reports such as trial balances. The usual practice is to put dollar signs beside only the first and last numbers in a column. 3. When amount are entered in the journal, ledger, or trial balance, commas are optional to indicate thousands, millions, and so forth. 4. Commas are always used in financial statements. 5. Companies commonly round amounts in reports to the nearest dollar, or even to a higher level.
McGraw-Hill/Irwin
Slide 61

EXERCISE
Problem
Prepare

2-2A (p.79) (Home Work)

Income Statement, Statement of Owner's Equity, and balance sheets for the business as of March 31, 2008.

Problem

2-4A

McGraw-Hill/Irwin

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A2

Debt to Assets Ratio

Total Debt Total Assets

Evaluates the level of debt risk.
A higher ratio indicates that there is a greater probability that a company will not be able to pay its debt in the future.
McGraw-Hill/Irwin
Slide 63

EXERCISE(p.73)
e

5. Bonaventure Company has total assets of $1,000,000, liabilities of $400,000, and equity of $600,000. What is its debt ratio (rounded to a whole percent)? a.250% b.167% c. 67% d.150% e. 40%

McGraw-Hill/Irwin

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Exercise 2-19(p.78)
a. Calculate the debt ratio and the return on assets using the year-end information for each of the following six separate companies ($ thousands).

Debt Co. Liabilities / Assets = Ratio

Net Income /

Average Assets = ROA

$56,000

$147,000

0.38

$21,000

$200,000

0.105

2
3 4 5 6
McGraw-Hill/Irwin

51,500
12,000 31,000 47,000 26,500

104,500
90,500 92,000 64,000 32,500

0.49
0.13 0.34 0.73 0.82

12,000
20,000 7,500 3,800 660

70,000
100,000 40,000 40,000 50,000

0.171
0.2 0.188 0.095 0.013
Slide 65

Exercise 2-19
b. Of the six companies, which business relies most heavily on creditor financing?
ANS: Company 6 relies most heavily on creditor (non-owner) financing with 82% of its assets financed by liabilities. c. Of the six companies, which business relies most heavily on equity financing? ANS: Company 3 relies least on creditor (non-owner) financing at only 13%. This implies that 87% of the assets are financed by equity (owners). d. Which two companies indicate the greatest risk? ANS: The companies with the highest debt ratios indicate the greatest risk. The two companies with the highest debt ratios are 5 and 6.
Debt Co. Liabilities / Assets = Ratio Net Income / Average Assets = ROA

1 2 3 4 5 6 McGraw-Hill/Irwin

$56,000 51,500 12,000 31,000 47,000 26,500

$147,000 104,500 90,500 92,000 64,000 32,500

0.38 0.49 0.13 0.34 0.73 0.82

$21,000 12,000 20,000 7,500 3,800 660

$200,00 0 70,000 100,000 40,000 40,000 50,000

0.105 0.171 0.2 0.188 0.095 0.013 66 Slide

Exercise 2-19
Debt Co. Liabilities / Assets = Ratio Net Income / Average Assets = ROA

1 2 3 4

$56,000 51,500 12,000 31,000

$147,000 104,500 90,500 92,000

0.38 0.49 0.13 0.34

$21,000 12,000 20,000 7,500

$200,00 0 70,000 100,000 40,000

0.105 0.171 0.2 0.188

5
6

47,000
26,500

64,000
32,500

0.73
0.82

3,800
660

40,000
50,000

0.095
0.013

e. Which two companies earn the highest return on assets? ANS: Company 3 yields the highest return on assets at 20%; followed by Company 4 at 18.8%. f. Which one company would investors likely prefer based on the riskreturn relation? ANS: As an investor, one prefers high returns at low risk. Company 3 is the preferred investment since it yields the lowest risk (debt ratio is 13%) and highest return on assets (20%).
McGraw-Hill/Irwin
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END OF CHAPTER 2

McGraw-Hill/Irwin

Slide 68