Question

True or False?

16	Year-end #1: Sales 200 with Cash 100 = + long-term debt 100 + capital stock 100 + opening retained earnings 0 + net income 50 + accounts payable 100 – accounts receivable 100 – inventory 50 - fixed assets 100. Year-end #2: Sales 400 with Cash 100 = + long-term debt 200 + capital stock 100 + opening retained earnings 50 + net income 50 + accounts payable 200 – accounts receivable 100 – inventory 100 - fixed assets 300. The company pays dividends instead of investing cash in its business.
17	The situation in question 16 means the sales increase was not profitable because Cash remained the same in Year-end #2.
18	The situation in question 16 indicates the firm’s long-term debt to equity improved in the Year-end #2.
19	Year-end #1: Sales 200 with Cash 100 = + long-term debt 100 + capital stock 100 + opening retained earnings 0 + net income 50 + accounts payable 100 – accounts receivable 100 – inventory 50 - fixed assets 100. Year-end #2: Sales 400 with Cash 100 = + long-term debt 200 + capital stock 100 + opening retained earnings 50 + net income 50 + accounts payable 200 – accounts receivable 100 – inventory 100 - fixed assets 300. The company uses profits to fund fixed assets.
20	Maintaining a current ratio is a negative covenant.

Answer 1

Solution-

16) True,

Year 1 sale is $200 and net income for that year is $ 50.In year 2 the sale is increased to $400 and net income is still $ 50.

If we goes by net profit ratio, then met income must be $100. There is certainly a change in either in COGS or dividend paid, since dividend paid is appropriation to income hence it should be reported after net income and divided is also adjusted from appropriation.

There may be increase in COGS or dividend might have been adjusted in income statement.

There is higher probability that dividend has been paid out of the current year profits and this net income has been decreased due to dividend paid adjustment in income statement.

Hence we have opinion that company is paying dividends to stockholders instead of investing profits in business.

17) False,

It cannot be said with respect to above explanation provided by me, that cash profits have not been earned. The cash profits has been earned but these profits seems to have been diluted out of business as dividends.

18) False,

No the company's debt to equity has not been improved since company has additionally obtained loan and company's profits have been paid by way of dividends.

19) True,

Company's profits along with debts obtained in year 2 has increased the fixed asset of the company in year 2.

The composition of contribution should be $100 from income and $100 from raising finance

Which make a direct increase of fixed asset by $200 in year 2.

20) False,

Maintaining current ratio is positive covenant.

Please comment for any additional explanation with respect to interpretation made by me,

Thanks