T.S. Grewal Class 12 Vol 3 Chapter 4 Q.49 - Accounting Ratios

Question 49

Assuming the Debt to Equity Ratio is 2:1, state, giving reasons, which of the following transactions would (i) Increase, (ii) Decrease, (iii) Not alter, the Debt to Equity Ratio:
(i) Issue of new shares for cash. (ii) Conversion of debentures into equity shares. (iii) Sale of a fixed asset at a profit. (iv) Purchase of a fixed asset on long-term deferred payment basis. (v) Payment to creditors.

Solution

Assume Debt = ₹2,00,000 and Equity = ₹1,00,000 (Debt to Equity Ratio = 2,00,000 ÷ 1,00,000 = 2:1).

(i) Issue of new shares for cash, say ₹50,000 — Decrease
Debt to Equity Ratio = 2,00,000 ÷ (1,00,000 + 50,000) = 2,00,000 ÷ 1,50,000 = 1.33:1

(ii) Conversion of debentures into equity shares, say ₹50,000 — Decrease
Reason: This is a debt-for-equity swap — Debt decreases by ₹50,000 (debentures cancelled) AND Equity increases by ₹50,000 (new equity shares issued), both at once.
Debt to Equity Ratio = (2,00,000 − 50,000) ÷ (1,00,000 + 50,000) = 1,50,000 ÷ 1,50,000 = 1:1

(iii) Sale of a fixed asset at profit, say ₹50,000 profit — Decrease
Reason: The profit increases Equity (Reserves); Debt is unaffected.
Debt to Equity Ratio = 2,00,000 ÷ (1,00,000 + 50,000) = 2,00,000 ÷ 1,50,000 = 1.33:1

(iv) Purchase of a fixed asset on long-term deferred payment basis, say ₹50,000 — Increase
Reason: This creates a long-term payment obligation, increasing Debt; Equity is unaffected.
Debt to Equity Ratio = (2,00,000 + 50,000) ÷ 1,00,000 = 2,50,000 ÷ 1,00,000 = 2.5:1

(v) Payment to creditors, say ₹50,000 — No Change
Reason: Trade Creditors are a Current Liability, not part of Long-term Debt; neither Debt nor Equity is affected.
Debt to Equity Ratio = 2,00,000 ÷ 1,00,000 = 2:1