Question

The 2019 annual report for a company includes the following items in its footnotes:
a. The useful life of machinery has been increased from 10 to 15 years.
b. The expected tax rate used to calculate income tax provision has increased from 33% to 38%.
c. The company has started to capitalize small tools purchased beginning in 2006.

For each of the above, determine the effect (higher, lower, or unchanged) of the change on the ratios listed below for the year 2019 and state the reason for the effect (increase(s) and/or decrease(s) in which accounts cause the change):

a. Debt-to-equity
b. Return on assets
c. Cash Flow from operations

Answer 1

1) The useful life of machinery has been increased from 10 to 15 years.

Impact : New depreciation would be remaining book value after accumulated depreciation divided by remaining estimated life. Hence it will be lesser than the previous year depreciation amount. Increase profit by deducting lesser depreciation amount and Book value of Machinery increases.

a. Debt-to-equity - This change will decreases the debt equity ratio as the profit increases the shareholder's fund will be increased and there is no impact in the long term liabilities.

b. Return on assets - This will increase the Return on assets ratio as there is an increase in the value of Net profit and Total assets.

c. Cash Flow from operations - This will reduce the cash flow from operations as the income tax paid will be higher compared to previously due to reduction in depreciation.

2. The expected tax rate used to calculate income tax provision has increased from 33% to 38%.

Impact : Decreases profit, Increase income tax provision amount and Decreases shareholder's fund. No impact in the total value of assets.

a. Debt-to-equity - Debt equity ratio will increase as the equity shareholders fund decreases and no impact in the Long term debt.

b. Return on assets- As the profit decreases, the return on asset will also decreases

c. Cash Flow from operations - Assuming the expected tax rate of 38% is the same as actual income tax to be paid then this will reduce the cash flow from operations once tax paid.

3. The company has started to capitalize small tools purchased beginning in 2006.

Impact : Increases profit, Increase Income tax amount and Increases Asset value

a. Debt-to-equity - Decreases Debt equity ratio as the equity shareholders fund increases due to increase in profit and no impact in the Long term debt.

b. Return on assets - Increases return on assets as the profit and value of assets increases.  

c. Cash Flow from operations - Capitalising purchase of tools will increase the profit and thereby increase the cash flow from operation as the purchase of tools will be cash flow from investment activity. However this will not impact Cash at Bank.