Question

The Debt Equity ratio is 3. What will be the impact on the following transactions, and find out the increase, decrease or no change in the ratio.

(i) Buy back of equity shares.

(ii) Purchase of a building on a deferred payment basis.

(iii) Issued shares in consideration of purchase of a machinery.

(iv) Debentures matured but not paid.

Answer 1

Debt Equity Ratio = 3 : 1

Let us assume, Debt = Rs 3,00,000 and Equity = Rs 1,00,000

(i) Buy back of equity share salary Rs 20,000
It will reduce the equity shares to Rs 80, and there will be no effect on debt.

Therefore, $\frac{\text{Debt}}{\text{Equity ratio}}$ = $\frac{3,00,000}{80,000}$ = 3.75:1 (Increases the ratio)

(ii) Purchase of building on deferred payment basis say Rs 50,000 it will not have any impact on equity but since payment is to be made on long-term basis it will increase debt to Rs 3,50,000.

Therefore, $\frac{\text{Debt}}{\text{Equity ratio}}$ = $\frac{3,00,000}{1,00,000}$ = 3.5:1(Increases the ratio)

(iii) Issue of shares for consideration of purchase of machinery say Rs 30,000

It will increase the equity shares to Rs 1,30,000

Therefore $\frac{\text{Debt}}{\text{Equity ratio}}$ = $\frac{3,00,000}{1,30,000}$ = 2.3:7 (Reduces the ratio)

(iv) Debentures matured but not paid say Rs 30,000.
It will reduce the debt since it is not a part of Current Liability which is to paid within a year hence debt will be Rs 2,70,000 and it will not have no effect on equity.

Therefore, $\frac{\text{Debt}}{\text{Equity ratio}}$ = $\frac{2,70,000}{1,00,000}$ = 2.7:1 (Reduces the ratio)