Question

The Debt-Equity Ratio of a Company is 1 : 2. Which of the following would increase, decrease or not change it ?

(i) Repayment of Long term Borrowings of Rs. 40,000.

(ii) Purchased a fixed Asset for Rs. 50,000 on long-term deferred payment basis.

(iii) Issued new equity shared of Rs. 75,000.

(iv) Payment of Dividend Payable.

(v) Goods purchased on Credit.

(vi) Payment to Trade Payables.

Answer 1

Debt-Equity Ratio $=\frac{\text{Debt}}{\text{Equity}}or\frac{\text{Long term Debts}}{\text{Shareholder's Funds}}$

In the above question, Debt-Equity Ratio is given as 1:2, therefore, it may be assumed that Long term Debts are Rs. 1,00,000 and Shereholder's Funds are Rs. 2,00,000.

(I) By the repayment of Long term Borrowings of Rs. 40,000, Long-term Debts will be reduced by Rs. 40,000, and these will stand at Rs. 1,00,000 - Rs. 40,000 = Rs. 60,000.

Therefore, the revised ratio will be :

$=\frac{\text{Rs. 60,000}}{\text{Rs. 2,00,000}}=0.3:1$

Before the repayment of Long term Borrowings, the ratio was 1 : 2 (or 0.5 : 1) which is now reduced to 0.3 : 1. It means that the ratio has decreased.

Therefore, it can be concluded that decrease in long-term debts decreases this ratio.

(II) As a result of credit purchase of a fixed asset for Rs. 50,000 on long-term payment basis, long term debts will increase by Rs. 50,000, and these will stand at Rs. 1,00,000 + Rs. 50,000 = Rs. 1,50,000. Therefore, the revised ratio will be :

$=\frac{\text{Rs. 1,50,000}}{\text{Rs. 2,00,000}}=0.75:1$

Before the purchase of fixed asset, the ratio was 1 : 2 (or 0.5 : 1) which now stands at 0.75 : 1. It means that the ratio has increased.

Therefore, it can be concluded that increase in long-term debts increases the ratio.

(III) By the issue of new equity shares, shareholder's funds will be increased and will stand at Rs. 2,00,000 + Rs. 75,000 = Rs. 2,75,000. Therefore, the revised ratio will be :

$=\frac{\text{Rs. 1,00,000}}{\text{Rs. 2,75,000}}=0.36:1$

Before the issue of equity shares the ratio was 1 : 2 (or 0.5 : 1) which is now reduced to 0.36 : 1. It means that the ratio has decreased.

Therefore, it can be concluded that increase in shareholder's funds decreases the ratio.

(iv) Payment of dividend payable means the payment of a current liability, Hence, there will be no change in debt-equity ratio because neither the long-term debts nor the Shareholder's funds are affected.

(v) Goods purchased on credit will affect only the Inventory and Trade Payables. Hence, there will be no change in debt-equity ratio because neither the long-term debts nor the Shareholder's funds are affected.

(vi) No change since both Long term Debts and equity remain unchanged.